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It can be extremely challenging when you think you have a buyer set in place to purchase your home and then find out they don’t qualify for a conventional mortgage or a government-backed mortgage. Fortunately, there are options. One option is the wrap-around mortgage.
A wrap-around mortgage can benefit parties on either side of the real estate transaction: buyers looking for their dream home and sellers looking to make a slow-burn profit. But a wrap-around mortgage is only possible if the seller has an assumable loan.
Wrap-around mortgages offer another financing avenue to buyers who may not qualify for a home loan or even want to pursue one.
The buyer can still get the home they want, and the seller often makes a profit on the sale. Still, it’s essential to know all the ins and outs of a wrap-around loan before moving ahead with this decision.
What Is a Wrap-Around Mortgage?
Let’s start by defining it. A wrap-around mortgage is a type of secondary financing that enables seller-financed property sales. This type of mortgage lets sellers keep their original mortgage and “wrap” a second mortgage around the first mortgage.
The seller essentially finances the sale of their home for the buyer, and the buyer makes monthly payments to the seller. Typically, the interest rate on the wrap-around mortgage will be higher than the interest rate on the original mortgage. The seller has a promissory note (think: a legal IOU) from the buyer indicating that they will make payments according to the loan’s terms.
How a Wrap-Around Mortgage Works
To help you get a better grasp of wrap-around mortgages, here are some key elements to consider:
- A wrap-around loan covers both the original mortgage and the difference for the new sale price. Let’s say a seller has an existing loan balance of $120,000 on their mortgage, and they sell their home for $175,000. Let’s say the buyer makes a 20% down payment, so they seller finance $140,000. That $140,000 wraps around the original $120,000 mortgage because the buyer will be making payments to the seller.
- A wrap-around mortgage is a new loan between the seller and the buyer. The buyer agrees to make monthly payments to the seller, which includes both the principal payment and interest charges.
- A wrap-around mortgage is only possible if the seller has an assumable loan. This type of loan allows for transfers from one buyer to the next. Unfortunately, assumable loans are quite rare.
- An alienation clause (aka a due-on-sale clause), which is a common feature of many mortgages, can prevent or complicate wrap-around mortgages. This clause requires that the original buyer pays off their outstanding loan balance before transferring the property to another owner. Ignoring this clause, and proceeding with a wrap-around mortgage can lead to legal consequences for the seller because they’re violating their contract with their lender.
For the seller
- The seller typically makes more on the buyer’s payment than their outstanding monthly mortgage because they sell at a higher price and often charge a higher interest rate. For example, the seller’s mortgage may be $500 a month, but they collect $750 a month from the buyer.
- Since a wrap-around mortgage is a type of seller financing, the seller gets to dictate the terms of the loan. Sellers can expect to define what they require for approval (think: qualifying credit score, income level, down payment, etc.). The seller is also responsible for drawing up the legal contract.
- Seller financing means that while the buyer owns the home, the seller still owns the original mortgage. If the buyer stops making payments, the seller will have to cover the missing payments. The buyer might lose the house, but the seller may have to contend with a damaged credit score and legal action from the lender if they can’t make the payments.
For the buyer
Home buyers often benefit from wrap-around mortgages for a few reasons. First, the approval process is usually easier than traditional financing. Also, they can negotiate factors such as the size of the down payment.
Example of a Wrap-Around Mortgage
Let’s say Lee took out a $350,000 mortgage with a 4% interest rate and currently has $50,000 left to pay on the mortgage.
At some point, Lee decides to sell the mortgage to Marley as a wrap-around mortgage. The sale price is $400,000 with a 6% interest rate and a $10,000 down payment. Lee is seller financing $390,000 for Marley at an interest rate of 6%.
Lee and Marley are both happy with the 6% interest rate because the going market interest rate is 7%. Marley is getting a deal and Lee is earning more than what they pay in interest.
Lee’s current mortgage payment is $1,670. Marley will pay Lee $2,338 and benefit from the quick approval process and great interest rate. Lee will get an additional $668 every month in profit on top of the $10,000 down payment.
Wrap-Around Mortgage Risks and Benefits
While a wrap-around mortgage offers benefits to sellers (a hard-to-sell property gets bought) and buyers (an easier-to-acquire loan), there are some risks both parties should be aware of.
Risks for sellers
Some of the risks for sellers include:
- Alienation clauses: If the seller’s mortgage has an alienation clause and they go through with a wrap-around mortgage, they’ll void their contract. If the lender finds out about the wrap-around mortgage, they can ask for the remaining loan balance upfront. If the seller can’t pay the balance, the home can be foreclosed on – and there may be other legal consequences for violating the contract.
- Risk of nonpayment: With a wrap-around mortgage, the original mortgage remains in the seller’s name. They may not own the house, but they are obligated to continue making their monthly mortgage payments. If the buyer stops making their payments, the seller has to cover the missed payments or risk having their credit take a hit.
- Seller financing: As a seller-financed loan, a wrap-around mortgage inherently comes with additional risks to the seller because there’s no protection from an intermediary (such as a financial institution).
Risks for buyers
The main risk for buyers is:
Losing your home: When buyers take on a wrap-around mortgage, they officially own the home. But they have no control over the seller making payments on the original mortgage. If the seller stops making payments, the lender can foreclose on the home. This means the buyer can lose their home even if they’ve stayed current on all their payments to the seller. Buyers can reduce this risk by having the contract state that payments will be made directly to the original lender rather than the seller.
Buyers are vulnerable because they’re dealing directly with the seller and relying on them to adhere to the contract.
Alternatives to Wrap-Around Mortgages
If you’re struggling to get a mortgage or you’re a seller having trouble finding buyers who can purchase, check out special programs from government-backed loans, like the Department of Veterans Affairs (VA), Federal Housing Administration (FHA) and U.S. Department of Agriculture (USDA) loans. Government-backed loans are a solid resource for buyers who don’t qualify for conventional mortgages.
You can also ask lenders what’s holding back loan approval. Most lenders are happy to share what you need to improve – whether that’s your credit score, debt-to-income (DTI) ratio or income. You could take this information and spend some time improving your financial situation so you can secure conventional financing in the future.
Now That We’ve Wrapped This Up, What’s Your Next Move?
In the right situation, a wrap-around mortgage can benefit both the seller and the buyer. As a seller, you want to feel confident that the buyer will make payments and offer an interest rate that’s more than what you currently pay. As a buyer, opt for a wrap-around mortgage if you trust the seller to make the payments or you can’t secure approval or a decent interest rate from lenders.
Always use a real estate agent or lawyer in a wrap-around transaction to ensure that all parties get a fair agreement.