How Does a Wraparound Mortgage Work?

A wraparound mortgage is an unconventional type of loan that can help both buyers and sellers. It can enable buyers to make the purchase, even if they can’t get approved for a traditional home loan or if the interest rate on a traditional mortgage would be too high. It can also be a profit-maker for the seller.

But wraparound mortgages come with serious risks that could make this form of seller financing not worth it. Here’s what to consider before you select this financing option.

[Read: Best Mortgage Lenders.]

What Is a Wraparound Mortgage?

In a traditional home purchase, the buyer obtains a mortgage loan and uses it to pay the seller for the house. The seller, in turn, uses that money to pay off the existing mortgage.

With a wraparound mortgage, though, the seller keeps the original loan and essentially “wraps” the buyer’s loan around it. The buyer makes monthly payments directly to the seller, who uses a portion to make regular monthly mortgage payments and keeps the rest.

The loan is made official when the buyer and seller sign a promissory note.

Because it’s a form of seller financing, which is generally more expensive than traditional home financing, the buyer typically pays a higher interest rate than the seller, providing a profit for the seller. (The average of the two rates is called the blended rate.) In exchange, the buyer gets the needed financing when no cheaper options are available.

How Common Are Wraparound Mortgage Loans?

Wraparound mortgages are an uncommon form of financing, primarily because the original mortgage lender must approve the secondary financing for it to be legitimate.

Most mortgage lenders require that you pay off the loan when you sell your home, so keeping the loan in place after you’re no longer the homeowner isn’t an option.

Wraparound mortgages are especially uncommon these days, when interest rates are so low. Buyers who might normally face high interest rates because of their credit or income situation may not be as interested in wraparound mortgages right now, says Doug Perry, strategic financing advisor at Real Estate Bees.

“A wraparound mortgage is worth considering when the blended rate is below what the borrower can get with a new mortgage,” says Perry. “With mortgage rates at low levels historically, wraps aren’t in play much.”

Wraps are more common when sellers are having a hard time finding buyers for their homes. In the current real estate market, sellers generally aren’t having a difficult time finding buyers, so they’re less likely to be interested in pursuing seller financing as a way to broaden the pool of options.

[Read: Best Mortgage Refinance Lenders.]

Wraparound Mortgage Benefits

While wraparound mortgages aren’t common and they do come with risks, they can have some benefits for both the buyer and the seller.

Buyers. Getting a mortgage can be difficult if your credit score is low or if your income situation is nontraditional. Conventional mortgages typically require at least a 620 credit score. While you can go lower with some government-backed loans — Federal Housing Administration loans go as low as a 580 credit score with a 3.5% down payment or 500 with a 10% down payment — interest rates can be high at those levels.

Also, if you’re a business owner or independent contractor, mortgage lenders will calculate your income using your last two tax returns. So even if your finances are in great shape at the moment, lenders may charge a higher interest rate if your last two returns show much lower income.

In either case, a wraparound mortgage can provide you with an opportunity to buy a home that you otherwise wouldn’t be able to finance, at least not affordably.

Sellers. For sellers, wraparound mortgages can provide an opportunity to generate a profit. As an example, let’s say you’re planning to sell your home for $300,000. Your original mortgage balance was $200,000, and with a 3% interest rate, you’re paying $843 per month in principal and interest.

You have buyers, but they can’t get approved for a standard mortgage loan, or their circumstances make it so the interest rate on a new mortgage would be higher than what they’d pay you via a wraparound mortgage. They give you a $30,000 down payment, and you agree to a 6% interest rate. The monthly principal-and-interest payment on the loan is $1,619.

As the buyers make monthly payments to you, you take $843 to pay your mortgage, then keep the remaining $776.

“The seller gets the clear benefit of being able to charge a high rate of interest for a loan,” says Tabitha Mazzara, director of operations at mortgage lender MBANC, “and that extra cash flow may be a help if they’re struggling to make the mortgage payment.”

And if you’re willing to take on the risks of a wraparound mortgage, this arrangement can be more profitable in the long run than selling the home outright.

Offering this and other forms of seller financing can also be a good way to expand your pool of potential buyers in the case of a buyer’s market where the supply of homes is greater than demand.

Wraparound Mortgage Risks

While there are some situations where it’s clear that a wraparound mortgage can be advantageous, the risks are high, especially if the seller is dishonest about being able to enter into such a contract.

Buyers. The seller’s mortgage is the primary loan on the home, so if monthly payments stop, the original lender, which holds the deed to the home, can foreclose and force you out of the home.

This can happen even if you’ve never missed a payment to the home’s seller. Fortunately, it’s possible to get around this by including in your agreement with the seller that you’ll pay the original home loan directly.

The other potential risk to buyers is if the seller agrees to a wraparound mortgage without the consent of the original lender.

“Some unscrupulous operators use a wraparound mortgage to get an unqualified borrower a loan by intentionally not disclosing the wraparound loan to the existing lien holder,” says Perry. “This creates a big problem when the scheme is uncovered.”

If the sellers breach their contract, the original lender may use an acceleration clause in the agreement to demand full repayment of the loan from the sellers unless they fix the problem, which may include your being forced from the home.

So if you’re thinking about getting a wraparound mortgage, Perry recommends seeking professional advice to ensure that the promissory note is legal and approved.

Sellers. For the most part, the risks to the seller are the same as to the buyer, just on the other side of the coin.

If the buyer stops making payments, that doesn’t stop your obligation to your original lender. And you’ll need to make sure your mortgage contract allows for this type of secondary financing, or you may run into problems with your loan.

On top of that, you also face the risk of damaged credit if the buyer stops paying and you can’t afford to make the payments on your own. Missed payments and foreclosure can have significant negative consequences on your credit score.

Despite the potential profits, it may not be worth it to put the fate of your credit history in the hands of another person. And while you could sue the buyer, Mazzara says you’re unlikely to benefit from it. “If they had the money, they wouldn’t be defaulting on the payments in the first place.”

Wraparound Mortgage Alternatives

Whether you’re a buyer or a seller, it’s crucial that you consider all of your options before settling on a risky one like a wraparound mortgage.

For buyers, that may include looking into government-backed loans with lower credit score requirements or simply waiting until your situation improves before you buy a home. If you’re having a hard time finding a mortgage because of an atypical financial situation, Mazzara recommends seeking out specialty mortgage lenders that can work with you without the added risk.

[Read: Best FHA Loans.]

If you’re a seller who’s having a hard time finding a buyer, you may look into alternatives to selling the home, such as using it as an investment property.

Whatever you do, it’s important to understand the risks involved with wraparound mortgages and to consider all of your options before you proceed with one.

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