What is a wraparound mortgage?

Wraparound mortgages are a financing option for real estate investors and traditional home buyers. In many cases, this can be a more desirable alternative to other non-traditional funding sources and can benefit both the buyer and the seller. However, wraparound mortgages also come with their own set of risks, so you should be well informed before getting into one.

In this article, we’ll explain what a wraparound mortgage is, how they work, weigh the pros and cons, and discuss alternative loan options to consider.

What is wraparound mortgage?

With a wraparound mortgage, the buyer becomes responsible for paying the seller the total purchase price of the property plus interest based on negotiated terms.

A wraparound mortgage is basically a secondary mortgage or junior loan that an investor or home buyer takes out directly with the seller instead of a traditional bank or lending institution. Instead of qualifying for a loan, checking credit history and meeting the requirements of a traditional institution, the buyer works out the terms of the loan and repayment with the seller.

How does a wraparound mortgage work?

Here’s where things get interesting: Even after the seller has sold their home to the buyer who has (presumably) moved out, they retain the existing mortgage on the property. The seller takes on the role of lender and provides financing for the buyer by “wrapping” the buyer’s loan into their original mortgage.

To finalize the agreement, the seller and buyer decide on a loan amount and down payment, then sign a promissory note outlining the terms of the wraparound loan. In doing so, the buyer assumes title and deed to the property. Then, the new property owner makes monthly payments to the seller at the higher interest rate, while the seller continues to pay the initial mortgage and pockets the difference.

While they can be confusing, wraparound mortgages have the potential to benefit all parties involved:

• The seller has made a profit based on the agreement made with the buyer
• The buyer becomes the new owner of the property without having to qualify for a loan from a traditional institution
• the original lender is still making payments

wraparound mortgage example

Here’s what a wraparound mortgage looks like in action:

Damon decides to sell his house for $300,000. His loan balance is $75,000 and is at a three percent fixed interest rate. Damon wants to sell Joel, but Joel is having trouble getting a secured loan because he has a bad credit score. However, Joel’s credit does not bother Damon as Joel has been consistently paying his bills on time for the past four years and makes enough money to comfortably afford a mortgage.

Damon and Joel agree to enter into a wraparound mortgage with each other, where Joel puts down $30,000 and will then make monthly payments on the remaining $270,000 at a six percent fixed interest rate. Damon then uses Joel’s down payment to pay off his mortgage, then makes a profit due to the three percent interest rate difference between his and Joel’s monthly payments.

Advantages and Disadvantages of Wraparound Mortgage

Wraparound mortgages come with a number of benefits and risks. Here are some of the main ones:

benefits

• Buyers and investors can buy properties despite having a high debt-to-income ratio (DTI), High DTI is a persistent deterrent for both new homeowners and investors looking to expand their portfolio. Wraparound mortgages require either no DTI of 43% or less or whatever percentage their potential lending institution requires.
• Buyers and investors can buy property despite having bad credit, To secure a conventional mortgage, a buyer must have a credit score of 620 or higher. While this can indicate whether someone will pay off their mortgage on time, this is not always the case. People can have bad credit for many reasons.
• New property owners can avoid paying private mortgage insurance (PMI), If you’re working with a traditional lender and don’t make a 20% down payment, you’ll need to pay PMI. Often, this is an additional $100 or more per month. In the example above, Joel pays Damon only 10% of the total purchase price ($30,000 for the $30,000 house). While Joel is paying a higher interest rate than Damon, he doesn’t have to pay PMI. To avoid PMI on $300,000 with a conventional lender, Joel would need to put $60,000 down.

risk

• The seller’s lender can demand full repayment after the property is sold, Wraparound mortgages usually let the lender out of this, but they don’t always have that option. After selling the property, the seller’s lender can demand full repayment. If Damon sells his property to Joel but still owes $75,000, Damon’s lender may need to pay it all before transferring title and deed to Joel.
• The seller may default on his loan, which could lead to foreclosure of the property, A wraparound mortgage requires the seller and buyer to trust each other to continue making payments. If Joel continues to make payments to Damon, but Damon stops paying his lender, the property could go into foreclosure. Conversely, if Joel stops paying Damon, and then Damon can’t continue paying, the same thing can happen.
• Higher interest rates can make wraparound loans worth less, Wraparound mortgages are usually mutually beneficial to the seller and the buyer. The buyer gets a property that they could acquire through conventional financing, while the seller makes money by charging a higher interest rate. In some cases, this interest rate can be very high. If Damon wanted to charge Joel 10% instead of 6%, Joel’s monthly payments would cost $750 more ($2,369 as opposed to $1,619, assuming Damon assumes this is a 30-year fixed rate). It may be more beneficial for Joel to look elsewhere or improve his credit and DTI ratios to eventually get approved for traditional financing.

Wraparound mortgage options

If you are a potential home buyer or investor struggling to obtain traditional financing, wraparound mortgages are one of your many options.

government backed loans

Home buyers have three unique options available to them.

• FHA loanFHA loans allow buyers with low credit cards to purchase homes with small down payments. If your credit score is 580 or higher, you can buy a home with three and a half percent down. If your score is 500 – 579, your down payment must be greater than 10%.
• VA loanVA loans are for veterans, active duty service members, surviving spouses, and others who meet comparable requirements.
• usda loanUSDA loans are part of a rural development loan program that offers special loans based on your zip code and county.

hard money loan

Hard money loans are short-term loans that use tangible assets as collateral in exchange for funding. These loans have shorter loops than traditional lenders, but have higher interest rates and are typically taken out by investors looking to fix up and flip properties. If you default on a hard money loan, you are putting your collateral at risk.

private loan

Personal loans are loans that you get from someone to buy an asset—in this case, property. A personal lender can be a family member, friend, angel investor, or really anyone who has extra cash and is interested in working with you. These loans tend to be more flexible than hard money loans, but you should pay close attention to their terms before signing anything.

Is Wraparound Mortgage Worth It?

Wraparound mortgages can be beneficial in some circumstances, but it all depends on your situation and the terms of your loan. A lot can go wrong with this type of agreement, so you need to be extra sure that on the other side of that promissory note is someone you can trust.

If you’re looking to enter into a wraparound mortgage but are struggling to come up with the right terms, start a discussion in the BiggerPockets forum. Our forums give you access to the world’s largest community of real estate professionals, and someone is always happy to help.

Note by BiggerPockets: These are the views expressed by the author and do not necessarily represent the views of BigPockets.