There are many different ways to purchase a house. You can get a typical mortgage or other types of financing from a third party. You can take out a line of equity on your old house. You can pay cash. Or you can get a wrap-around mortgage loan.
Although not often used, a wrap-around mortgage can have many benefits for the seller and the buyer. In this article, we'll dive into wrap-around mortgage loans, how they work, and the benefits and risks for all parties involved.
Wrap-Around Mortgage vs. Typical Mortgage
When getting a typical mortgage, you'll usually go through your bank or a mortgage broker. The process usually looks something like this:
Susan wants to buy a house but needs a loan to buy it. She goes to a mortgage broker who takes a look at her credit history as well as her debt-to-income ratio and approves her for a loan. Bobby buys a house for $200,000 with a fixed interest rate, puts 10% down, and pays all the closing costs and fees involved with purchasing the house.
Because Susan got a 30-year loan, she will pay the monthly mortgage payment until she pays the house off or until she sells the home.
A wrap-around mortgage, on the other hand, is a form of seller financing. In a wrap-around mortgage, the buyer treats the seller as the bank at makes monthly payments to the seller. The seller still has a mortgage and uses the money from the buyer to pay toward the existing mortgage.
The seller usually considers owner financing when their house isn't selling due to market conditions or other issues, such as the house is in need of some repairs. While buyers often go to wrap-around mortgages when they can't get approved for a loan, others prefer wrap-around mortgages to other forms of financing because they are able to negotiate better rates.
Here's an example of a wrap-around mortgage loan.
Joe wants to buy a house but can't get approved for a loan through a mortgage broker because he is still working to build his credit. He finds Tina who is selling her house and willing to do a wrap-around mortgage with Joe.
Tina needs to do a wrap-around mortgage because she still owes $60,000 to the original lender and has a 6% interest rate. Tina gets a down payment from Joe along with the secured promissory note describing the terms of the sale. The promissory note outlines the terms of the sale, which are:
Joe will buy the house for $200,000 and put down a 10% down payment. He is essentially financing $190,000 from Tina. Joe agrees to make monthly mortgage payments to Tina with 8% interest, which is a higher interest rate than Tina pays toward her original mortgage each month.
Both Joe and Tina are happy because Joe now has the house he wants and Tina is making enough from the wrap-around mortgage to continue to pay toward the original loan as well as make money from interest.
Benefits of a Wrap-Around Mortgage
As you can see in the above example, both parties benefit from a wrap-around mortgage. The seller receives a profit in the form of interest each month and the buyer is able to get a house without needing to qualify through a lender.
Often, the buyer will purchase the house and refinance for a lower interest rate before the notes are due. They will then pay off the seller and have more of a typical loan structure.
If the buyer is an investor, they'll have the benefit of structuring the financing terms. This is a great benefit to the investor if they are buying a rehab project, as they will be able to get the house for little-to-no money down and sell or rent out the home at the end of the rehab and make money on the venture.
Drawbacks of a Wrap-Around Mortgage
A wrap-around mortgage is a secondary form of financing also known as a junior mortgage. "Junior" mortgage means that any superior claims have priority. If the seller defaults on the loan, for example, the original lender could foreclose on the property and would take the proceeds until their debt was satisfied, leaving the buyer high and dry.
Another drawback to a wrap-around mortgage is the risk the seller takes on. If the seller used an FHA or VA loan for their original mortgage, the mortgage should be assumable. Assumable means the owner of the property can transfer the loan and the new owner can assume the property without penalty from the original lender.
If the mortgage is not assumable, however, the seller could be facing big problems from their lender if and when they find out. Many un-assumable loans have a due on sale clause where the entire lump sum of what is owed is immediately due on the sale of the house. Because the seller is not receiving a lump sum, they may not be able to pay the sum to the mortgage, causing them to default on the loan.
Both parties assume massive amounts of risk when using a wrap-around loan.
Are wrap-around mortgages a good idea?
Wrap-around mortgages work out much of the time. They are a good idea if the original lender is on board with the buyer assuming responsibility for the loan and the contract is written well enough to withstand any scrutiny or pressure that may be placed on it.
Wrap-around mortgages provide great opportunities for buyers and sellers alike if the situation is right. Make sure to do your due diligence as the buyer or the seller in this transaction, as the other party's character is what this transaction will depend on.
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