A wraparound mortgage is an unconventional type of loan that can help both buyers and sellers. It can enable buyers to purchase a home, even if they can’t get approved for a traditional home loan or if the interest rate on a traditional mortgage is too high for them to afford. It can also be a profit-maker for the seller.
This lesser-known financing option is an alternative to traditional home loans for buyers and sellers in unique circumstances. But wraparound mortgages come with serious risks that could make this form of seller financing not worth it.
[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 their 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 currently is, 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 your 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 when interest rates are low. Buyers who might normally face high interest rates because of their credit or income situation may not be as interested in wraparound mortgages when rates are favorable, 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.”
[Read: Best Mortgage Refinance Lenders.]
When Is a Wraparound Mortgage a Good Idea?
While wraparound mortgages aren’t common and they do come with risks, they can have some benefits for both the buyer and the seller.
Benefits to Buyers
— A wraparound mortgage can be easier to get with low credit. Getting a mortgage can be difficult if your credit score is low. 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.
— A wraparound mortgage can be easier to get if your income situation is nontraditional. 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.
— The closing process may be faster and cheaper. Because you are dealing with an individual, not a bank, the underwriting process may go more smoothly and costs may be lower.
Benefits to Sellers
— You can earn 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 an 9% interest rate. The monthly principal-and-interest payment on the loan is $2,172.
— You can increase your cash flow. As the buyers make monthly payments to you, in this example, you take $843 to pay your mortgage, then keep the remaining $1,329. “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.”
— You can increase your potential pool of buyers. Offering wraparounds 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.
What Are the Risks of a Wraparound Mortgage?
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.
Risks to Buyers
— The seller could stop making payments. The seller’s mortgage is the primary loan on the home, so if the seller stops making monthly payments, 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 seller didn’t get approval for a wraparound mortgage. “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.
— A more expensive mortgage. A wraparound mortgage will always be more expensive than an optimal traditional mortgage. You might be better off improving your credit and financial situation and qualifying directly.
Risks to Sellers
— The buyer could stop making payments. If the buyer stops making payments, that doesn’t stop your obligation to your original lender. 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.
— You need to get permission. 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.
— Additional headaches. Now you’re dealing with your original lender, plus the buyer of the house, and really you’re dealing with two monthly mortgage payments. Cashflow problems and paperwork issues are sure to arise over the lifetime of the loan.
Wraparound Mortgage Alternatives
If you’re worried about qualifying for a traditional mortgage, a wraparound mortgage is not the only option. There are several borrowing options for those with bad credit, including the following:
— Department of Veterans Affairs loans. Available to active-duty military members and veterans, VA loans typically have lower credit requirements and more favorable interest rates than traditional mortgages.
— FHA Loans. An FHA loan is also a good option for those with less-than-perfect credit or for borrowers who are unable to secure a 20% down payment on their mortgage amount. Loans could be available with a down payment as low as 3.5%.
— U.S. Department of Agriculture Loans. USDA loans are available exclusively to buyers in certain rural areas, and they might come with more flexible qualification requirements and repayment terms that are more achievable than conventional loans.
— Fannie Mae HomeReady or Freddie Mac Home Possible Loans. These loans offer a path to homeownership for borrowers with lower incomes who do not have a credit history. If you do have a credit history, a minimum credit score might still apply.
Some loans may be limited to particular groups or might have higher interest rates, so be sure you can afford any extra costs. Continuing to rent a home while you work to improve your credit score or save for a higher down payment might save money in the long run.
[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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Update 09/29/23: This story was published at an earlier date and has been updated with new information.