Wrap-Around Mortgages Explained: What are they? How do they work?
Wrap-Around Mortgages Explained: What are they? How do they work?
Close in as little as 7 days.
Over 53 years of lending success.
Solutions for all situations.
What is it?
Simply put, wrap-around mortgages are a special type of mortgage that is made directly between seller and buyer without a bank or other lender to serve as an intermediary. They are typically made for seller-financed home mortgages, but they can be (and in past years were frequently) used for purchases of real commercial real estate that have low interest rate first mortgages in place. This kind of loan works by “wrapping around” the seller’s first mortgage, which remains in place after the sale. The buyer takes possession of the property and pays the seller an amount that exceeds the seller’s monthly mortgage payment and the seller continues the payments to the lender holding the initial mortgage. The wrap-around mortgage concept was extremely popular in the 1980s, but is not nearly as common today.
How does it work?
The seller has a property valued at $100,000, with an existing mortgage for $80,000 at 6 percent; the buyer offers the seller a down payment of $20,000 and agrees to pay the remaining $80,000 at 8 percent interest (this amount is referred to as “real debt”). This allows the seller, or note holder, to earn a 2 percent profit on the wrap-around mortgage while providing the necessary funds to make the first position mortgage payments.
Who typically gets them?
(1) Buyers with bad credit or who are otherwise unable to get a loan from a bank or other traditional lender. (2) Sellers who need to sell close quickly or who have had difficulties selling their property. The seller must be willing to accept long-term monthly payments for part of their payment instead of an immediate lump sum, which would result from the typical deal where the buyer gets a new loan and the seller immediately takes out all of their equity
What are the risks?
This type of mortgage is extremely high risk and based on trust that both buyer and seller will continue to make the required payments. The buyer has to trust that the seller will apply the wrap-around loan payments towards the initial mortgage or the lender will foreclose on the property. Conversely, if the buyer defaults on the wrap-around, the seller will be forced to foreclose on that loan before the original lender decides to foreclose on the property itself. There is also a risk to both buyer and seller from the seller’s lender as mortgages typically contain a “due on sale” clause which allows them to demand payment of the loan in full when the property changes hands. It can be a good idea to approach the lender about the potential wrap-around loan in advance to avoid this complication. In the world of commercial mortgages it is strongly advised that a purchaser work with their real estate attorney before considering this type of financing.
What are the rewards?
Wrap-around mortgages can provide a path to homeownership for buyers who cannot qualify for traditional bank loans. When interest rates are on the rise, they can also allow buyers to benefit from the seller’s lower initial interest rate. For example, if the banks are lending at 8 percent, but the seller’s property is mortgaged at 5 percent, the seller may be willing to extend a loan to the buyer at only 6 or 7 percent. Sellers can benefit by being able to unload property they can’t afford to keep in when the housing market is in a slump. The interest they collect on the loan also gives them an effective rate of return on their equity. Wrap-around loans also have the added benefit of quick closing times and reduced, or eliminated, closing costs.
Important steps to follow when considering a wrap-around loan:
- Agree upon the sale price and offer and put it in writing.
- Determine the interest rate. This is usually close to what is being offered by traditional lenders, but must be adjusted so that it is above what the seller is paying on the initial loan.
- Review the papers on the seller’s current mortgage and ensure that the wrap-around mortgage will not violate it. This should be done with legal counsel.
- Arrange a closing date by consulting with an attorney or escrow officer.
- Maintain a detailed record of payments on both mortgages in order to protect both buyer and seller.
Wrap-around mortgages can reward both seller and buyer, but it is important for both to understand and consider the risks before entering into this type of high risk financial agreement.
This blog was written by Bob Amter, President of Montegra Capital Resources, LTD., a Colorado hard money lender. [google_authorship] has been in the private capital lending business for 41 consecutive years.