A wraparound mortgage is a structured loan transaction where the home seller continues to be responsible for the existing mortgage.
This means that even though the ownership of the property changes hands, the previous owner continues to be the borrower of the existing mortgage.
In effect, the seller is financing the purchase of the buyer.
The lender is this case is the home seller instead of a traditional bank.
Payments are made by the buyer to the seller, who in turn make deductions to pay the debt obligations to the original lender.
For example, a seller who has a $75,000 mortgage at 5% on the house sells it for $90,000 at 100% financing at 6% interest. This transaction would net the seller 6% on $15,000 for the agreed term, plus the 1% difference on the original $75,000.
Not too shabby!
This deal helps the seller sell at a higher price and profit from higher market rates of 6% that the new loan is set against.
Still attractive to buyer
While such a deal can seem to be outrageously unfair to the buyer, there are various reasons why a buyer would still find the offer attractive.
A wraparound mortgage eliminates need for the buyer from applying for a traditional mortgage from the banks.
This saves time and effort from all the hassle of application work. There’s also a possibility that the rate offered by the seller might still be lower than the market rate.
For example the market rate might be 7%. Because the seller’s existing mortgage rate is 5%, dealing at 6% helps both the seller to earn and the buyer to save.
All this without even having to pay for the costs of closing the loan.
There’s also the small inconvenience of buyer possibly having bad credit.
Thus being unable to get a loan approved. And even if approval is granted at the requested loan quantum, the buyer could be subject to higher interest rates.
A traditional lender would also have caps on the loan to value that the buyer could qualify for.
With a wrap, the seller can potentially finance 100% of the purchase.
Furthermore, if the buyer intends to resell the property to a second buyer at a higher price, he could possibly made a tidy profit without even have to fork out his own capital.
Risks of wraparound transactions
As you can see, a wrap can be very profitable for a seller.
And with higher returns comes higher risks.
While the buyer will be the one taking on the new debt, the seller is the one assuming most, if not all, of the risks.
Because the new owner has little to no equity in the house, he might abuse it as there is no feeling of ownership and responsibility.
This would be no problem as long as the buyer meets the debt obligations to the seller diligently. But there is no guarantee that that would happen over the long run even with a promissory note favoring the seller.
This lack of home equity also means that if there is a decline in property value, the house can easily run into negative equity territory. Leaving the buyer with little financial incentive to upkeep it.
Should the buyer start to default on the loan, the seller will have no choice but to take on the burden of the foreclosure process.
Are wraparound mortgages legal?
From a legal standpoint, only assumable mortgages can be legally wrapped.
These refer to mortgages where the lenders have no problems with a third party take over the obligations of the debt.
FHA and VA loans for example, are assumable without requiring to seek the permission of the lender.
While there are investors who go about wraparounds and keeping them secret from the lender to avoid triggering the due on sale clause, they are walking a tight rope and might already have contingency plans in place for protection should they be found out.
If you are new to home buying and investing in real estate, this really is not the arena to test your ability and competence.