Wraparound Mortgage - Explained
What is a Wraparound Mortgage?
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Table of ContentsWhat is a Wraparound Mortgage?How Does a Wrap Around Mortgage Work?Example of a Wraparound MortgageRisks of using a Wraparound MortgageBenefits of a Wraparound MortgageAlternatives to a Wraparound MortgageKey Takeaways
What is a Wraparound Mortgage?
In economics, a wraparound mortgage is a unique financing option that allows a mortgage owner to get a second mortgage to support the payment of the original real estate mortgage plan. A wraparound mortgage is also known as an agreement for sale, a wrap loan, or an all-inclusive mortgage. The original property buyer extends some form of junior mortgage to the second buyer, which serves as an additional payment plan to any mortgages that the property secures. Meaning, the wraparound loan will now comprise of the new loan from the buyer and the outstanding balance of the superior loan.
How Does a Wrap Around Mortgage Work?
Under the wraparound mortgage, the buyer gives the seller a secured promissory note, which is a legal document acknowledging the debt. A wraparound mortgage is a subordinate financing plan where both parties are using one real property as insurance. The new buyer makes payments to the seller in monthly installments, who then uses that money to pay his superior mortgage. Although the seller keeps paying for their superior mortgage, they are no longer the owner of the property. The new buyer receives the title deed after they sign their wraparound agreement. A wraparound mortgage, not like other mortgage contracts, is a seller financing option, where, when the new buyer fails to make the payments, the seller has the right to take back the real estate property. The sellers lending institution can also foreclose on the property in case both parties completely default. To prevent the foreclosing, the seller should use the payments from the buyer to pay the lending institution. Usually, the interest rates of wraparound mortgages are higher than normal mortgages. For example, a seller can be having a mortgage at a 5% interest rate. He/she decides to sell the property on a wraparound mortgage at a 7% interest rate, making a 2% profit on each monthly payment. In a wraparound mortgage, the lending institution, the seller, and the buyer all agree on the loan payment plan. Since there is a transfer of ownership from the seller to the buyer, the lending institution has a legal right to call superior mortgages due, if there is a due-on-sale clause on the mortgage. Sellers who want to use the wraparound financing option need to find buyers who are willing to finance that kind of mortgage. Most lending institutions do not advocate for a wraparound mortgage, but some allow only when the superior mortgage is assumable.
Example of a Wraparound Mortgage
A seller wants to sell their real estate property for $200,000 because he is unable to pay off the remaining amount. The balance on his mortgage is $25,000, with a 3.5% fixed interest rate. After consulting with the lending institution, they allow him to use the wraparound mortgage option. He finds a buyer who agrees to pay $200,000 for the property. However, the buyer does not have all the money so, he puts down $10,000 and borrows $190,000 from the seller, under a wraparound agreement at a rate of 4.9%. Both the buyer and the seller sign the mortgage agreement, and the seller transfers ownership to the buyer. The buyer pays the seller every month according to their agreement, and the seller uses that money to pay off his superior mortgage. Since the buyers interest rates are higher than the seller's interest rate, the seller makes some profit out of the wraparound.
Risks of using a Wraparound Mortgage
The due-on-sale clause on the mortgage is a risk that can destroy a wraparound agreement before it commences. If the initial contract between the bank and the seller has a due-on-sale clause, then the bank may call the mortgage due and requires the seller to clear the balance. In case the seller is unable to pay off the debt, the bank can foreclose on the property, and both the buyer and the seller will remain with nothing. When a seller has more equity in a property, then the risks of issuing a wraparound mortgage becomes high. Meaning, when the buyer defaults on the payments, the seller will still have to pay the superior mortgage to the lender. Also, the buyer must pay a certain amount of legal fees so that he can foreclose on the buyer. The bank can foreclose on the seller in case he is unable to cater to the expenses. For the buyers, their major risk factor is when the seller defaults on his mortgage payments. To lessen this risk, the buyer can craft the mortgage documents in a way that he can directly pay the sellers lending institution. By doing this, the bank credits the payments against the sellers payment agreements.
Benefits of a Wraparound Mortgage
An investor that has a bad credit history has the opportunity to purchase a real property under the wraparound financing option. Since a wraparound mortgage is a contract between the seller and the buyer, the two parties can negotiate interest rates amongst themselves and avoid using traditional methods. The decision-making process and the purchase process for a wraparound mortgage are generally fast.
Alternatives to a Wraparound Mortgage
- Land contracts
A land contract and a wraparound mortgage have many similarities, but their major difference is the ownership transfer process. With land contracts, the buyer pays the seller small amounts until he clears all the payment. Once the buyer makes all the payments, the seller transfers full property ownership to the buyer.
- Traditional mortgage financing
Various government-sponsored financing programs allow investors with poor credit histories to take a mortgage. The Federal Housing Administration (AHA) gives loans to investors who have credit scores of 580, and allow down payments of 3.5%. Most buyers, especially low-income earners and self-employed people, qualify for VA mortgages which have a 0% down payment.
- A wraparound mortgage is a seller financing method where the seller assumes the place of the lender bank.
- The seller mostly uses the wraparound mortgage when he is unable to pay off the superior mortgage.
- The seller makes profits when he mortgages a property at an interest rate higher than the original rate.
- The buyer gives the seller a secured promissory note to acknowledge the debt.