Advantages and Pitfalls of ‘Wraparound’ Loan
QUESTION: My wife and I have been trying to sell our house for some time. We purchased the house about 15 years ago, and we have an existing assumable mortgage that carries a very low interest rate. Recently, a friend told us about a “wraparound” mortgage. Can you tell us how this works, and whether it would have any advantages or disadvantages for us?
ANSWER: Wraparound mortgages gained popularity during the period of high interest rates in the mid-1970s and again in the early 1980s.
A wraparound mortgage works like this: You have an existing mortgage with a present balance of $80,000 at 8% interest, and you would like to sell your house for $150,000. Your purchaser is able to come up with 20% of the purchase price, or $30,000, and would have to obtain a loan for $120,000 to buy your house.
One way to achieve this financing is for the purchaser to apply for a conventional 80% loan. Under this arrangement, the purchaser would have to pay appraisal and credit report charges, as well as points, which could be as high as $3,000 (three points).
Alternatively, the purchaser could assume your existing first trust (mortgage) and seek second trust financing for all or a portion of the remaining money above the first, which in this case would be $70,000.
Of course, the interest rate on the second trust will be higher than the interest rate on a new first trust. However, the combined effective interest rate (and the combined monthly payment) may not be greater than a single first trust in the higher amount.
A third way of working with this situation would be a wraparound mortgage. Under such an arrangement, the purchaser would first assume your existing mortgage.
You would then give to the purchaser what amounts to a second trust on the property for the full amount of the financing ($120,000), although at the beginning of the loan, you are really only lending $40,000.
Keep in mind, because you have not advanced all of the $120,000 at the inception of the loan, you may make a “profit” on the difference between the interest rate of the first trust and the interest rate on the second trust. The result to you is a yield (profit) in excess of the amount of interest stated in the second trust.
To be more specific. If you take back a second trust in the amount of $120,000 at, for example, 10%, and you continue to make the interest payments at 8% on the existing $80,000 first, you will be making 2% on the existing $80,000, and a full 10% on the $40,000 difference that you are in fact lending to your borrower.
This situation may seem too good to be true, but there are problems also.
Although usury laws have been relaxed in recent years, once in a while you run into a situation where local law requires certain conditions or imposes certain limitations on a second mortgage. You should also discuss this with your attorney, to make sure that you are not violating any local law.
Your buyer may also object to this format since it may inhibit his ability to place further financing on the property. Rather than being encumbered by a single loan, the property will be subject to total liens of the first and second mortgages in the amount of $120,000.
This may inhibit the ability of the purchaser down the road to obtain a home-equity loan, since the lender would no doubt be in third-trust position, unless you are paid in full on your wraparound.
The purchaser may be somewhat hesitant to rely on you to make payments on his or her behalf. You can often solve this problem, however, by agreeing to send monthly or quarterly proof of payments to your borrower by sending him a copy of your monthly canceled checks.
In some instances, the seller can give the borrower a year’s worth of postdated checks, and the borrower then sends the monthly payment check to the first trust lender each month on time.
Under the proper circumstances, a wraparound mortgage can be both practical and advantageous. It certainly can be a marketing tool when real estate is difficult to sell, since it assures the buyer that a loan is available, and clearly saves the buyer a lot of up front lender costs.
You must make sure, however, that your loan is freely assumable. Additionally, since there is always the possibility that your borrower may default, you want to make sure that the wraparound deed of trust and promissory note that your buyer signs is valid and enforceable in your jurisdiction. It is advisable to have an attorney prepare the necessary legal documentation in this case.
Kass is a Washington lawyer and newspaper columnist specializing in real estate and tax matters. While questions cannot be answered individually, those of general interest will be addressed in this column. Questions and comments may be sent to Kass at 1050 17th St. N.W., Suite 1100, Washington, D.C. 20036. Kass is also the author of the Homebuyer’s Checklist. The booklet is available for $5 and can be obtained from the National Homeowners and Homebuyers Assn. at the above address. Please send a mailing label to expedite processing.
