If you have watched any television in the last month or so, you’ve probably seen one (or many) of the commercials for the “125% Mortgage.” There are several lenders who are offering such programs, but they all work pretty much the same way–you purchase a home and the lender gives you 125% of its value. You pay the seller and put the extra 25% in your pocket. They are touted as a great way to pay off credit card debt, take vacations, pay for a college education and more. But for the average homebuyer, are they a good deal?
On the surface, these 125% mortgages appear to be an excellent way of getting the maximum leverage from your home purchase, and, on that level, they succeed. You do have extra cash that you can do with as you please, whether it is to pay off old debts paying cash for something instead of incurring new debt.
If you dig just below the surface, though, you’ll find that there may be some major pitfalls lurking there. The first, and potentially the most expensive, is the fact that you will be locking yourself (unless you dig deep into your pockets) to the home for a long time. Since the interest in mortgages is “front loaded”–meaning that the bulk of your early payments are long on interest and short on principal–equity comes very slowly. As an example, let’s say that you purchase a $125,000 home with a 125% mortgage. The loan amount, without factoring in closing costs, will be approximately $156,000. If you stay in the home 5 years–and make all of your payments on time–before you decide to upgrade (pretty normal for most first-time buyers) your balance after 5 years will be in the $148,600 range. If home prices rise at the current average of around 2% per year and you maintain your home adequately, your property should be worth in the $138,000 range. But, you owe $148,500, a shortfall of over $10,000. In this example, if you sell your home through a Broker who charges, say a 6% commission ($8280) and have rather normal selling expenses of 1% ($1380) and closing costs of about the same amount, your shortage now totals over $21,500. If home prices stagnate–or go down, which has happened in the past–this number could be even bigger! To sell your home, you would need to come up with this amount–in cash. Plus, since you have no equity in the home, you will need to come up with additional cash for both downpayment and closing costs on the new home.
“Well,” many buyers say, “at least the interest on our mortgage payment is tax deductible. Our credit card interest isn’t.” True, but only to a point. The IRS has ruled that mortgage interest is only deductible UP TO 100% of the home’s value The extra 25% usually is not deductible. (See a tax specialist for full details).
For some buyers, these mortgages may make sense. If you are absolutely certain that you will not be moving for 10 -12 years or more–difficult with potential job changes, family size changes and the like–you may not get hurt. If, however, you need–or want–to move in less time than that, they could be a very expensive proposition. Instead, our advice would be to spend more time on budget planning–tougher to be sure but a whole lot more beneficial.