Lets Wrap…

Many of the properties we buy (and a few that we sell for that matter) and done via Seller Financing. Often times when buying via seller financing, an existing mortgage exists.  Many people believe that if a property has a mortgage, that seller financing is not an option.  That’s not the case. There is a very effective and perfectly legal way to easily sell a property that has a mortgage. It’s called a “Wrap”, or “Wraparound Mortgage”.

The traditional way to purchase a house, which is becoming harder to do lately, works like this: Sally the Seller owns a home she wants to sell for $200,000. She owes $150,000 to Bank #1, who has mortgage and first lien. After listing the property for sale, Billy the Buyer decides he wants to buy, and they agree on the $200,000 price. Billy and Sally sign a sales contract and Billy begins the process of trying to get a loan.

Billy applies for a new mortgage from Bank #2 (who serves more as a ‘loan origination’ rather than a lender, as I’ve written about before).  Bank #2, in order to decide if they want to loan Billy money, needs to qualify him via a set of conforming guidelines (which are not necessarily up Bank #2 to come up with). They ask him for years of tax returns. They run his credit. They ask for pay stubs or other proof of income.  They go back and forth with more forms. More questions… If they like Billy, they then need to decide if they like the property. They ask him to pay for a new survey. A new appraisal. There is an inspection. They’ll want lender fees, closing fees, document fees, recording fees, plus whatever other fees they might feel like charging that day.

If Bank #2 likes Billy and the property, they’ll ask Billy to put down about 20% ($40,000 in this case) and will do a loan for the remaining $160,000. At closing, Bank #2 pays off the original $150,000 mortgage owed by Sally to Bank #1 (which makes that lien go away). The rest of the loan and down payment funds are used to pay closing costs to the title company, commissions to the Realtor, and any prorated taxes.  Whatever is left goes to Sally.  Billy is now the new owner and Bank #2 has a new $160,000 lien.

With a wraparound mortgage, things work a bit different.  Sally still owes $150,000 to Bank #1, who has a first lien on the property. Billy enters the same contract to buy this house for $200,000. However this time Billy does not apply for a new mortgage. With a wrap, Sally acts as the lender.  At closing, Billy can still put down the same $40,000 (or any other number they might agree on) which goes to Sally, and a promissory note is created for the $160,000 balance.

Sally gives Billy a deed and Billy is the new legal owner of the house (Sally also has a deed of trust or wrap around mortgage to secure her payment from Billy). The only difference is the lien from Bank #1 still exists.  Each month, Billy pays Sally a monthly mortgage payment, which Sally uses to pay Bank #1.  Billy’s new loan is “wrapped” around the existing loan from Bank #1.

The easiest and “cleanest” way to setup a wrap is to make the terms of the new loan match the terms of the old loan (as far as interest rate, amortization, possible balloon date, etc.). This is how we setup our deals almost every time. If that’s a possibility, then its technically feasible for Billy to make payments directly to Bank #1.  He continues to do so till the loan is paid off, or the property is sold.  However, the buyer and seller can ‘wrap’ the existing mortgage with completely different terms.

How does that work? Billy still pays Sally payments based on their note, however the payments paid to the Sally are entirely dependent on the note agreement between them.  Meaning the amount paid by the Sally to Bank #1 is irrelevant to Billy (though if the amount due to Bank #1 exceeds what the Billy owes Sally, there is extra risk to Billy.  That risk can be mitigated somewhat but that’s more complex than I want to type here). Billy pays Sally based on their note, and Sally pays Bank #1.  Since the two notes do not match, it’s possible that Sally could have a note with Billy for $160,000 that pays 8%, while she pays her $150,000 loan to Bank #1 at 5%. So she’ll make 8% on the $10,000 equity difference, and a 3% spread on the amount she owes Bank #1.  If there was additional equity and Sally saw a need for cash in the future, the wrap could have been setup with a balloon payment on Billy’s note. Then Billy still can get into the house easily, but can refinance on his own schedule, perhaps when lending rules have changed again (so long as it’s before the balloon date).  When a refinance (or a sale of the property by Billy) takes place, Bank #1 and Sally are paid off and out of the picture and a new note is made with Bank #2.

Advantage of a wrap. So all this seems pretty complex — why bother?  What are the advantages of doing a wrap?  Here are a few:

• The biggest advantage is time. It allows buyer and seller to agree to a fair price between them, and get the deal done without the need to involve Bank #2 and all the hassle involved with getting a new loan.
• It often allows the seller to get a better price as the costs and time normally spent by a buyer when dealing with Bank #2 are no longer there. Meaning a buyer is typically going to be willing to pay more for this option.
• If a wrap is done for an amount higher than the existing loan, then the seller has the chance to receive an income from their equity (vs. the 1% they might get from Bank #1, who is happy to lend back at a much higher rate).  Also, depending on the terms, the full wrap note could be at a higher interest rate than the existing note with Bank #1.  This allows the seller to not only make a nice return on their equity, but they’ll make a good ‘spread’ on the difference in interest between what the buyer is paying and what the seller owes.
• It allows deals to simply get done that wouldn’t otherwise due to the “quality” of the buyer.  Many buyers are perfectly capable of making a mortgage payment but may not be capable of getting a loan for a number of reasons. So rather than keeping a house on the market waiting for a pristine buyer to pay (who will want a discounted price), the seller can typically get a higher price and close faster.
• It allows deals to get done that wouldn’t otherwise due to the property:  This is where we most often take advantage of wraps.  Most of the properties we buy are great for us, and make great financial sense, however that doesn’t mean a “Bank #2” is going to agree.  Maybe it’s the greatest building in the world in the best location  but totally vacant for someone reason.  “no no” says Bank #2. So by wrapping a property we can get into the investment, fix what a bank might not like, and then refinance with Bank #2 once it’s stabilized.  For us this is typically multifamily apartment buildings but the same theory could apply to a distressed single family home where a buyer liked the property but a bank perhaps wouldn’t due to a condition that a buyer can easily fix after the sale.

Disadvantages of a wrap:  So all that sounds WONDERFUL!  Why doesn’t everyone do it? The main disadvantage is almost every mortgage contains a “Due-on-sale” clause, which states that if ownership of a property is transferred, that mortgage must be paid first.  If a property is sold (and ownership is transferred) without paying off the mortgage,  Bank #1 could “call the note due”.  Meaning no more monthly payments to Bank #1.  They want to be paid back in full, now.

It’s important to note that the due on sale clause does not make wraps illegal. It doesn’t mean a wrap is not considered a default. It’s not even a violation of the mortgage.  It just means that Bank #1 now has the “right” to call the note due.

As unlikely as it is that a bank would ever exercise this right, the “Due on sale” clause is a risk to the buyer and seller.  With with all things, the risk must be weighed against the benefit   People that have heard me talk about wraps have heard me say that a wrap will put you on the list of people who bank wants to scald.  But you’ll be at the bottom of that list.  And that list is LONG. The last thing a bank wants to do is call a note due and risk a possible foreclosure  Banks want to make loans and be paid interest.  So long as the payments continue to be made, the bank has no reason to call the note due.  Currently banks are facing a historically high number of non-performing loans, and tons of property dumped on their laps. If one day all those get cleared up, they might start to worry about people doing wraps that are otherwise performing.

I did a bit of research, so as not to rely on solely my anecdotal evidence, and couldn’t find a single case of a note being called due if there were otherwise no issues with the mortgage (out of potentially millions of wraps done).

Summary: With the current challenges buyers (even otherwise qualified buyers) face in getting traditional loans, seller financing — including seller financing using wraps, is becoming more and more common.  I say this as someone who has not only researched the issue, but as someone who has bought and sold many properties using a warp mortgage. So if you’re looking to buy or sell, a wrap might be something to consider.

Hope you found this interesting. Happy investing!

– Cody