A wraparound mortgage, also known as an overriding mortgage, is an alternative for buyers who are struggling to get traditional financing. It gives a break to buyers who are struggling to get approved for a loan and allows sellers to make a profit on the sale and financing of their property.
A wraparound mortgage comes in handy when the buyer is not qualified for a traditional mortgage loan. It benefits both the buyer and seller. The buyer gets the much-needed financial support to purchase the property, while the seller can make a profit on the sale and financing of the purchase.
A wraparound loan has some serious risks involved, but also benefits. So let’s take a deep dive into everything that you should know about it.
What is a wraparound mortgage?
A wraparound mortgage, also known as a carryback loan, is an unconventional home loan where the seller of the property also acts as the lender. It allows buyers to qualify for a loan, even if they don’t qualify for a traditional mortgage. A wraparound mortgage allows a lender to increase the return on the sale of the property. It is particularly attractive to sellers who are struggling to find buyers who qualify for financing.
How do wraparound mortgages work
Let’s look at the steps of an ordinary real estate transaction, first. The buyer gets a mortgage loan from a mortgage lender, purchases the home, and later on, the seller uses the sale proceeds to settle their existing mortgage on the home.
In a wraparound mortgage, the seller keeps the original mortgage on the home and offers seller financing to the buyer. This seller financing arrangement works as a junior loan, that wraps around the original loan. The seller acts as a lender here, and remains on the existing mortgage but, they are no longer listed or considered as the owner of the home.
Wraparound mortgages in 3 steps
- Step. 1: Once the buyer and seller agree to a wraparound loan, the seller must obtain approval from the original mortgage lender to proceed.
- Step 2: The buyer and seller can agree to a loan amount and down payment, followed by a promissory note signed by both parties. The promissory note includes the terms and conditions of the wrap loan and passes the title and deed on to the buyer.
- Step 3: The seller gets a monthly mortgage payment from the buyer, and continues to pay for the mortgage taken from the original lender.
Since the wraparound mortgage behaves as a second mortgage — also known as a junior mortgage — the original lender has the power to foreclose on the house, if the seller fails to pay the outstanding mortgage.
This type of loan usually has a higher interest rate than a conventional mortgage. If the seller is using the monthly payment they receive from the buyer to pay off the existing mortgage, they have an opportunity to make a profit from the secondary loan.
However, there are many alternatives to this financing method that typically provide more favorable terms to the buyer. Consider getting rates from at least three lenders before considering this kind of alternative financing. The comparison tool below is a good place to start.
How common are wraparound mortgage loans?
Wraparound financing was quite popular in the ’80s when the interest rates were in double digits, but in the present-day market, not so much. One of the main reasons behind this is the current low-interest-rate environment. However, they are rare now and it’s unusual that a wraparound mortgage can be used lawfully to purchase a property when there is an existing first mortgage in place. Note that there is a transfer of legal title from the seller to the buyer. And most mortgages have a “due on sale” clause that requires payment in full of the outstanding loan balance upon the seller transferring legal title of the property. In most cases, the mortgage agreement treats the wraparound arrangement as a “sale” for the purposes of the due-on-sale clause.
A wraparound loan is worth considering when the interest rate of a new mortgage is higher than the blended rate of the wraparound mortgage. When conventional mortgages already have low interest rates, buyers do not show interest in wraparound mortgages. On the other hand, the sellers are required to pay off the first mortgage even after selling the home. Pursuing a wraparound mortgage to settle a mortgage balance of a home that they no longer own does not make sense for most sellers.
Wraparound mortgages are a useful financing method when sellers struggle to find buyers. But in the contemporary real estate market, sellers do not find it that hard to find buyers, so they are less likely to opt for a secondary financing option of this kind.
A wraparound mortgage example
Let’s see how wraparound mortgages are used in real estate with an example. Imagine you want to sell your home for $250,000, and you have a remaining balance of $75,000 on your mortgage.
After putting your home on the market, you find a buyer who accepts the sales price of $250,000, but they are not qualified to get a mortgage loan from a traditional lender. A wraparound mortgage can help you close the deal.
Now you contact your mortgage lender and obtain permission from them to participate in the secondary financing, and proceed with the wraparound agreement. Assumable loans, such as FHA loans, USDA loans, and VA loans can be involved in wraparound mortgages.
Let’s say that your buyer came up with a down payment of $15,000 and plans to borrow the remaining $235,000 of your sales price by entering into a wraparound mortgage agreement with you. The buyer makes the monthly payments directly to you and you can make monthly payments to the original lender until you pay off the original mortgage balance of $75,000.
Eventually, you should be able to earn a profit by keeping the difference between the amount your buyer pays you and the amount you use to settle the monthly payments of your original mortgage.
Wraparound mortgages appeal to the buyer when the interest rates in the market are higher, and they can use this type of loan to get a lower interest rate. They can also be used by sellers to reduce their tax liability. But if you’re the buyer, you can probably find a better option in the current market. Here are SuperMoney’s guides to comparing the best mortgage and mortgage refinance lenders.
Wraparound mortgage vs. second mortgage
A wraparound mortgage may look like a second mortgage, but they are important differences to consider.
A second mortgage is a loan that you get against a property that already has a mortgage on it. It uses the borrower’s home equity as insurance, so in case you default on your loan, you could face foreclosure. The equity is calculated from the difference between the purchase price of your home, and the principal balance of your first mortgage.
The process of obtaining a second mortgage is quite similar to the one you followed in the first one. There is a series of documents that you need to submit to the mortgage lender. You will typically require the lender to make an appraisal to confirm the value of your home. You need to have some equity built up in your home, and based on your home value and the remaining loan balance, the lender will decide whether to agree to the wraparound mortgage.
In a secondary mortgage, the second loan is taken in addition to the primary loan, but in a wraparound mortgage, the second loan is included in the primary loan, along with an extra amount. Wraparound mortgages are a seller financing method, while second mortgages are usually not used to finance the sale of the property that secured them. Instead, second mortgages are a flexible financing option that leverages the equity you have built in your home.
While the funds received from a wraparound mortgage can only be used for the property that you obtained the loan against, the second mortgage allows you to use the borrowed money for many different purposes — home repairs, home improvements, and consolidating other debts to name a few.
Benefits of a wraparound mortgage
Wraparound mortgages benefit both the buyer and seller.
As a buyer
The biggest benefit for a buyer is the opportunity to get financing even without a proper income situation or good credit scores. A conventional mortgage requires a credit score of 620, while wraparound mortgages settle for less. There are certain government-backed loans like FHA loans that require lesser credit scores (around 580), but the interest rates are less favorable.
As a seller
With a wrap loan, the seller gets the advantage of making a profit. It also attracts more buyers, with its lower interest rates than the current ones in the market. The are also tax advantages attached to selling a property in this fashion.
Note that if the seller chooses to receive payment for the property in installments it can provide desirable tax advantages as well as convenient financing for the buyer. As Robert Liquerman and Diane Di Franco explain in their paper That Tax Consequences of Wraparound Mortgages:
“The installment method of reporting allows a taxpayer who is to receive at least one payment after the year of a disposition of real property to recognize income as the proceeds are actually received. The use of an installment sale permits a seller to spread income over time and thereby avoid liquidity problems that could arise if the entire gain is recognized before full payment is received. However, the benefits afforded the seller by installment reporting may be lost if the purchaser “assumes” property “subject to’ an existing underlying mortgage.”
Wraparound Mortgage Risks
When you are agreeing to a wraparound mortgage, seller or buyer, there are a few risks to keep an eye on.
As a seller
A wraparound loan includes the risks of a traditional mortgage. As a seller, you have to make sure that the monthly payments of your original loan are paid as required. The payments must continue until the full mortgage is paid off, so even if your buyer stops paying, you should make the payments on time. If you miss a payment, the mortgage lender can foreclose on your mortgage.
Your original mortgage may include a due-on-sale clause, which states that the seller must pay off the remaining balance of the mortgage when it is sold or transferred. In such cases, you are not allowed to take part in a wraparound mortgage. The lender may request you to pay the existing mortgage in full using the profit of your home sale.
As a buyer
The buyer faces the risk of seller default. While you make monthly payments to the seller, there can be a situation where the seller does not pay off his original loan properly. If that happens, the lender can still foreclose on the home.
How to get a wraparound mortgage
Since the wraparound mortgage is a seller financing option, you should first speak to the seller of the home that you are interested in buying, and check whether there is a possibility for it.
If you are a seller who is preparing for a wraparound mortgage, contact your lender and get approval from them to proceed.
Wraparound mortgages have many benefits, especially for a buyer who has limited funds and credit score problems. It can also become a nice profit-maker for the seller. However, there are risks involved, for both parties. Whichever side you are on, you should probably consult with an experienced real estate attorney before agreeing to this type of financing.
Wraparound Mortgages – FAQs
When a buyer uses a wraparound mortgage, who makes the payment on the first mortgage?
The seller. While the buyer pays the wraparound mortgage, the seller is still obligated to pay off the existing loan balance even after selling the home and transferring the ownership.
Can wraparound loans help your buyer purchase a home?
Absolutely. Wraparound loans can be obtained even with bad credit scores and poor financial history.
Is a wraparound mortgage legal?
Yes, they are as long as the initial lender agrees to the wraparound mortgage and there isn’t a clause in the mortgage that cancels the loan if the property is sold. However, some concerns have been raised during recent years due to the due-on-sale clause.
Who is responsible for the underlying loans when a wraparound is created?
The seller is. The buyer makes the payments to the seller, and the seller is responsible for making the payments to the underlying loans.
- A wraparound mortgage is a type of secondary financing given by the seller, to a buyer who is not qualified for a traditional loan.
- The loan works as a junior loan that wraps around the existing mortgage.
- The buyer makes a monthly mortgage payment to the seller, and the seller continues to pay off the original mortgage.
- The seller can eventually make a profit out of it.
View Article Sources
- Alternate financing – NC Real Estate Commission
- Unwrapping the wraparound mortgage foreclosure process– Washington and Lee Law Review
- The tax consequences of wraparound mortgages – Journal of Civil Rights and Economic Development