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Should You Use A Wrap Around Mortgage?

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What Is a Wrap Around Mortgage?

By Robert Duplicki      October 2, 2021

A Wrap Around Mortgage, also known as an All Inclusive Trust Deed (AITD), is a form of financing in which a new promissory note equal to the purchase price of an asset, minus the down payment, wraps or includes an existing loan. The funds paid on the wrap around mortgage are used to pay the existing loan, while also paying the remainder of the purchase price to the seller.

For example, let’s say I own a property that has an existing loan of $100,000 and I am able to sell that asset for $200,000 with 10% down. Instead of paying off the existing loan, I create new seller financing for $180,000. The buyer makes payments to me for the $180,000 financing, and I use part of the proceeds to keep making the payments on the existing loan, known as the underlying loan.

Why would I do this? Depending on my situation, and that of my buyer, there are advantages for both of us. I will get into more specifics below. I will also add the perspective of a note buyer, and how selling a wrap around mortgage is another potential benefit to the property seller.

The use of the term wrap around mortgage versus all inclusive trust deed will vary depending on whether you are in a state that uses mortgages or trust deeds. While their use is common with residential real estate, they may also be used in the sale of commercial real estate and businesses. A wrap around mortgage would need to dovetail with the commercial mortgage covenants.

In past articles and other parts of this website, I have described the benefits of seller financing for both sellers and buyers. Wrap around mortgages are another tool that fits in with these benefits. While seller financing is often connected with “for sale by owner” transactions, you will find that wrap around mortgages are also a tool often used by real estate agents.

Here is the definition of a wrap around mortgage from the Century 21 glossary:[2]

“Wraparound mortgages are typically done by allowing the person who is selling a home to provide a mortgage to the person buying the home. These loans are most commonly used when the first mortgage on the home is an assumable loan. However, in some cases, they may be used on non-assumable loans with the original lenders permission.

The total wraparound mortgage amount is the full amount of the existing loan plus the new amount that is borrowed. One payment is made by the borrower to the seller and the seller then makes the payment on the original loan. Typically, the interest rate is higher than the interest rate that is on the existing mortgage.

For sellers, the higher-yield on the mortgage makes this an attractive option when selling their home. When the primary mortgage is a non-assumable loan, the lender must agree to this scheme or there is a risk they will call the loan requiring the loan to be paid in full.”

Keep in mind that the use of wrap around mortgages by real estate agents will be affected by their required fiduciary duties and the viewpoints of their brokers. The flexibility offered through seller financing is usually open to other viewpoints.

Benefits Of A Wrap Around Mortgage

  • The seller of the property increases their rate of return because the interest rate on the wrap mortgage is higher than the rate on the underlying, or first mortgage.

  • As an alternative, the buyer could assume the first mortgage, and the seller could hold a second mortgage. By using the wrap around instead, the seller continues to make the payments on the first. So the seller maintains more control of the process.

  • For properties with high loan balances, there can be difficulty finding financing that works. Wrap around mortgages can provide a solution for such situations, for both FSBO’s and listed properties.

  • For investors, wrap around mortgages provide a way to flip properties with seller financing. The idea is to acquire houses in good shape knowing that you have an interested buyer. This works if you have access to the financing to make the purchase and can quickly sell on a wrap..

  • If a buyer has an adequate down payment , the wrap could provide all the financing needed to acquire a property or a business. This might be the only way some buyers will be able to make a deal with certain sellers. Otherwise they may not be in a position to make such a purchase at all.

  • For the buyer the process is easier than qualifying for a conventional or government-insured loan. Once they qualify, they pay no points, bank fees or private mortgage insurance.

  • There are additional benefits of seller financing that apply to wrap around mortgages as well. I have covered these in other articles listed under "Further Reading" below.

Concerns For Buyers And Sellers

  • The seller is still responsible to make the payments on the underlying mortgage. As with the ownership of any property, the seller faces their own personal risks which could affect their ability to pay their financing costs.

  • Likewise the buyer is responsible to make the payments on the wrap around mortgage. Their own personal risks could impact this process.

  • As with any business decision that the seller makes, this one might not work out. Proper due diligence as recommended on this website will minimize these risks. That process combined with the favorable return on investment, makes seller financing attractive. And the choice to use seller financing should make sense based on your situation.

  • The buyers may have other financing options that they would prefer. But the sellers may have determined that they will use a wrap around mortgage to sell their property or business. Everything is negotiable. What do you need to make this deal work for you?

  • Most mortgages have a due on sale clause. This clause gives the lender the right, but not the obligation, to ask for payment in full upon the sale or transfer of the property securing the mortgage.

The Process

As an introduction, this section is not meant to be a complete list of all steps that should be taken to complete a wrap around mortgage. But this description along with the other sections of this article should give you plenty of input to work with.

For starters, either the seller or buyer of a property or a business, needs to feel that using a wrap around mortgage could be a beneficial way to finance a deal. Then, do you understand the technique well enough to proceed or do you need to learn more?

A seller ready to proceed needs to find a buyer. Are you going to do a “for sale by owner’ or list with an agent? Either way you should be prepared to offer seller financing, and there is plenty more information about that on this website.

Likewise a buyer could be the one who first becomes acquainted with a wrap around mortgage, or other aspects of seller financing. Then you could start looking for a business or a property to buy, that is offering seller financing. Or perhaps you find the asset you wish to purchase, but seller financing is not being offered. The seller may have no interest in it at first. Can you sell the concept of seller financing in order to make your purchase?

Sellers should decide whether they are only willing to accept a wrap around mortgage as financing, or what other options are acceptable. Is seller financing a requirement? If so, is there a reason why only a wrap around mortgage works for you?

Specific terms will need to be agreed upon. This includes price, down payment, interest rate, frequency of payments, amount of payments, length of amortization, possible balloon payment, special clauses, current balance on the underlying loan(s) and amount of the wrap around mortgage. What would you prefer and what is a requirement? Would you consider interest only payments? Could no payments for six months work? How about stepped payments?

Just like the sale of any property or business, you need to close the deal including all the procedural steps. How much can you do on your own, and who else do you need to get involved? From start to finish you should have access to skilled professionals you can contact with your questions and to close your deals. Make sure they have a solid understanding of the geographic area where you are doing your transactions.

The down payment along with the other terms are negotiable. Buyers and sellers will have different goals and may have preconceived views based on bank financing and similar advice. Seller financing allows you to agree on a down payment without such restrictions. But this isn’t meant to encourage the seller to take nothing. Lower down payments tend toward more risk. This risk could be compensated for through a higher price, interest rate, or both.

If you plan to sell the wrap around note, you will find ideas about down payments on this website. Being a wrap doesn’t change things.

One idea for you to consider is additional collateral. What does the buyer own that cold be used as additional collateral for the wrap around note? Or what does the buyer own of value that could be added to the cash down payment. Anything acceptable to the seller could work.

The amount of the wrap around note is equal to the sales price minus the down payment. This amount includes the balance of the underlying note(s). The difference between the balance and the underlying note(s) is the seller’s equity.

It is possible that there were already two notes recorded against the property or business. In that case the wrap around note would be a third lien, and could be written to wrap around either the first or second note or both.

The interest rate selected for a wrap around note also offers flexibility, and you could find a variety of opinions about it. In general, seller financing is considered subprime financing which carries a higher rate than conventional financing. But this will depend on the motivations of the seller. A higher interest rate will help to reduce the discount if you sell the note.

One view suggests that a wrap around mortgage is not needed in times of low interest rates. While this may be true for most buyers in times like these, seller financing is always in use for a variety or reasons.

Certainly when interest rates are higher, and more buyers are having difficulty affording what they want, a wrap around mortgage will be of greater use.

More specifically a wrap around mortgage is intended to be a form of seller financing in which the seller makes a profit. This is done by charging a higher interest rate on the wrap than the underlying loan(s). The profit can be noticeably increased if the term of the underlying loan concludes before the wrap around note. From that point on the payments made to the seller would no longer need to be used to make payments on the underlying loan. So the seller's cash flow will increase.

The seller's equity would also increase over time if the underlying loan is amortizing quicker than the wrap around note. This would happen because of the shorter lenght of the note or a lower interest rate. In either case more of the payment is going toward the reduction of principal.

The Terminology And Related Opinions Can Be Confusing

It might be suggested in other resources that a wrap around mortgage is also called carry-back financing or a contract for deed among other things. While a wrap is a form of carry-back financing, they are not synonymous. And using the term “contract for deed” does not mean that a wrap around mortgage is being used. So be careful as you read other materials that may be helpful, but mislead you with inaccurate terminology.

As I’ve mentioned, one of the key benefits of seller financing is flexibility. By comparison, some of the related advice you will find about such financing will make statements as if they are factual and have to be that way.

For example, “A wraparound mortgage is a type of seller financing offered by homeowners which features a below-market interest rate.” It could be offered by homeowners. But it also could be offered by a commercial property owner or a business owner. It might feature a below-market interest rate but it usually doesn’t. And that is so for a variety of reasons mentioned on this website.

So be aware that what appear to be reputable sources of information may face limitations, also for a variety of reasons.

Speaking of terminology, a wrap around mortgage might use the spelling wrap around, wraparound or even wrap-around. But please don't make up any others!

Tax Considerations

Here's some information that I hope you find helpful. But I'm not a tax advisor, so consult with the right professional for you.

Seller financing does have tax benefits. In my article Seller Finance Your Business you will find further thoughts in the section "Installment Sales". While that article focuses on business notes, the concepts also apply to real estate. In the same article I have also provided information about 1031 Exchanges, which can be done in conjunction with installment sales.

Installment Sales are a key tax benefit of seller financing provided for in federal income tax law. This allows you to pay taxes on your profit as you receive it, which is spread out over time. So recognition of income is deferred to the time of the actual payments, rather than in the year of sale.

From the tax standpoint of an installment sale, the goal is to reduce the income received at the time of sale. A related concern is if the IRS feels that you have received debt relief, this would increase your taxable income in the year of sale.

Above I mentioned that as an alternative to a wrap around mortgage, the buyer might be able to assume the existing mortgage, and the seller could hold a second mortgage. Another option investors like to use to acquire property is taking it subject to the existing mortgage. But for the seller these methods can pose tax issues.

In simple terms, mortgages assumed or taken "subject to" by the buyer provide debt relief to the seller. And debt relief results in more income received in the year of sale. So a key benefit of the wrap around mortgage is that “The purchaser pays the seller the full value of the property and makes no payments to the seller's mortgagee; therefore, he does not relieve the seller of the original mortgage debt on the property.“”[3]

The IRS has fought this issue for years taking the position “that the wraparound mortgage is deemed to be a "subject to" mortgage for tax purposes.”[4]

The good news is “The Tax Court has repeatedly held that when a well-planned wraparound mortgage is utilized in an installment sale, the purchaser does not assume or take property subject to an existing underlying mortgage.”[5]

If you utilize a wrap around mortgage, keep in mind the concept of debt relief which may also be impacted by State regulations.

Due On Sale Issues

"A due-on-sale clause is a clause in a loan or promissory note that stipulates that the full balance of the loan may be called due (repaid in full) upon sale or transfer of ownership of the property used to secure the note. The lender has the right, but not the obligation, to call the note due in such a circumstance."[6]

When a wrap around mortgage is being implemented, there is a good chance that the underlying mortgage is provided by a bank, and that the loan documents contain a due-on-sale clause. In such a case the lender wants to know if this clause is being triggered.

The lender then has the choice to call the loan due, recast it at current market rates, or take no action. The seller and the buyer doing the transaction would of course like to have the lender’s written agreement to take no action.

From a practical standpoint wrap around mortgages are often done between buyer and seller without contacting the lender. Of course if the underlying loan does not contain a due-on-sale clause, no problem.

A key point is that the lender has the option, not the obligation to call the loan due. To enforce this provision the lender would need to foreclose. Banks do not like to foreclose and are not likely to do so when the payments on their loan are being made. This process involves time and money and taking back a property that they don’t want.

As long as the buyer and the seller understand the risks involved, and put their understanding in writing, a wrap around mortgage can be a very effective tool. With the help of a professional, consider having the mortgage documentation address:

  • that the seller warrants to promptly make the underlying loan payments

  • the possibility that the underlying mortgage company calls the loan due

  • he possibility of default by the payor(the property buyer) of the wrap around mortgage

A Note Buyer’s Perspective

Wrap around mortgage notes can be sold for cash. This involves selling a stream of payments for a lump sum of cash. The difference between the amount of the wrap around mortgage and the underlying loan(s) is the property seller’s equity. This is an asset available to sell. The note buyer purchases the note and the right to make payments.

Throughout this website the factors that make a note more attractive to a note buyer have been covered in detail. The basics include higher interest rates, larger down payments, desirable security ie. the property or the business, better credit histories, an on time payment history and notes that will be paid off sooner.

From this group of factors above what is actually chosen will be based on the circumstances of the property or business seller and buyer. What works best to put the deal together may not produce the ideal note in the eyes of a note buyer. But it will help to be mindful of these factors in advance, whether you plan to sell the note in the future, or not.

Ideally there will be a spread between the interest rate of the underlying mortgage and the wrap around mortgage. The greater the spread the more profitable the wrap around note should be. This potential profit will be balanced in the eyes of note buyers by the perceived risks. And the perceived risks will vary from one note buyer to another.

Just as there are different reasons to use seller financing to sell a property or a business, there are different reasons to sell the note. Those reasons can vary over time. So will the level of motivation to sell the note.

What is different about selling a note written in conjunction with a wrap around mortgage, is less equity than the average seller financed note. Having less equity is part of what makes the wrap around mortgage a winning solution to sell your property or business. But when the note is sold, there is also less of an asset being sold as well.

In some cases if the seller’s equity is very low, the seller may need to pay cash in addition to the note, in order to sell the note. This may help the seller if the seller no longer wants to deal with the underlying mortgage and the wrap process. Selling the note will also remove this debt from the seller’s credit history.

One way or another the underlying mortgage needs to be dealt with. A typical approach is for the note buyer to require that the underlying mortgage is paid off when purchasing the wrap around note. This will offer more protective equity to the note buyer by moving the wrap around mortgage into first position. Remember that a wrap mortgage is recorded after any underlying liens.

If the note buyer is more comfortable with the property, payor and the note characteristics, they could purchase the entire wrap and leave the underlying loan in place. This would provide a better rate of return for both the seller and the note buyer. Remember that the full yield is only received after all payments have been made.

Further Reading

Seller Finance Your Business

Owner Financing Will Put Money In Your Pocket

The Pros And Cons Of Seller Financing - Part1

The Pros And Cons Of Seller Financing - Part2

Do You Have A Mortgage Note For Sale?

References

  1. Image by Mohamed Hassan from Pixabay
  2. Century 21 Glossary, Wraparound Mortgage
  3. Nebrask Law Review, Volume 61 Issue 3, Receipt of Payment in Installment Sales Transactions: Wraparound Mortgages and Letters of Credit, by Chris A. Horacek chrome-extension://efaidnbmnnnibpcajpcglclefindmkaj/viewer.html?pdfurl=https%3A%2F%2Fdigitalcommons.unl.edu%2Fcgi%2Fviewcontent.cgi%3Farticle%3D2004%26context%3Dnlr&clen=3194048>
  4. Ibid.
  5. Journal of Civil Rights and Economic Development, Volume 2 Issue 2, The Tax Consequences of Wraparound Mortgages, by Robert Liquerman and Diane Di Franco https://scholarship.law.stjohns.edu/cgi/viewcontent.cgi?referer=&httpsredir=1&article=1624&context=jcred
  6. Wikipedia https://en.wikipedia.org/wiki/Due-on-sale_clause

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