A wraparound mortgage is a financial option for real estate investors and traditional home buyers. In many cases, it can be a more desirable alternative to other non-conventional funding sources and can benefit both the buyer and seller. However, wraparound mortgages also come with their own set of risks, so you should be well-informed before getting into one.
In this article, we’ll explain what a wraparound mortgage is, how they work, weigh the pros and cons, and discuss alternative loan options worth considering.
What is a Wraparound Mortgage?
With a wraparound mortgage, the buyer becomes responsible for paying the seller for the property’s total purchase price plus interest, based on the negotiated terms.
A wraparound mortgage is basically a secondary mortgage or junior loan that an investor or home buyer takes out directly with the seller instead of a traditional bank or lending institution. Instead of trying to qualify for a loan, credit history checks, and meeting a conventional institution’s requirements, the buyer works out the loan and repayment conditions with the seller.
How Does a Wraparound Mortgage Work?
Here’s where things get interesting: Even though the seller has sold their home to the buyer (assumably) moved out, they maintain the existing mortgage on the property. The seller takes on the lender role and provides financing for the buyer by “wrapping” the buyer’s loan into their original mortgage.
To finalize this agreement, the seller and buyer decide on a loan amount and down payment, then sign a promissory note outlining the terms of the wraparound loan. Upon doing so, the buyer assumes the property’s title and deed. Then, the new property owner makes monthly payments to the seller at a higher interest rate while the seller continues paying down the initial mortgage and pockets the difference.
While they can be confusing, wraparound mortgages have the potential to benefit all parties involved:
- The seller turns a profit based on the agreement they’ve made with the buyer
- The buyer becomes the new property owner without having to qualify for a loan from a traditional institution
- The initial lender is still getting paid
Wraparound Mortgage Example
Here’s what a wraparound mortgage looks like in action:
Damon decides to sell his house for $300,000. His loan balance is $75,000 and at a three percent fixed interest rate. Damon wants to sell to Joel, but Joel is having problems getting a secured loan because he has a bad credit score. However, Joel’s credit doesn’t bother Damon because Joel has been consistently paying his bills on time for the last four years and makes enough money to afford a mortgage comfortably.
Damon and Joel agree to enter into a wraparound mortgage with one another, where Joel puts $30,000 down and then will make monthly payments on the remaining $270,000 at a six percent fixed interest rate. Damon then uses Joel’s down payment to pay down his mortgage further, then turns a profit between his and Joel’s monthly payments thanks to the three percent interest rate difference.
Pros and Cons of a Wraparound Mortgage
Wraparound mortgages come with many benefits and risks. Here are some of the main ones:
Benefits
- Buyers and investors can purchase property despite having a high debt-to-income ratio (DTI). High DTIs are a frequent barrier for both new homeowners and investors looking to expand their portfolios. Wraparound mortgages don’t require either to have a DTI of 43% or lower or whatever percentage their prospective lending institution requires.
- Buyers and investors can purchase property despite having bad credit. To secure a conventional mortgage, a buyer needs to have a credit score of 620 or greater. While it can indicate whether someone will pay their mortgage on time, this isn’t always the case. People may have poor credit for numerous reasons.
- New property owners can avoid paying private mortgage insurance (PMI). If you’re working with a traditional lender and don’t make a 20% down payment, you’ll have to pay PMI. Often, this is an additional $100 or more per month. In the example above, Joel only pays Damon 10% of the total purchase price ($30,000 for the $300,000 home). While Joel’s paying a higher interest rate than Damon, he doesn’t have to pay PMI. To avoid PMI on $300,000 with a traditional lender, Joel would need to put $60,000 down.
Risks
- The seller’s lender may demand full repayment once the property gets sold. Wraparound mortgages usually leave the lender out of it, but they don’t always have this option. The seller’s lender may demand full repayment once the property gets sold. If Damon sells his property to Joel but still owes $75,000, Damon’s lender could require that he pay for all of it before transferring the title and deed to Joel.
- The seller could default on their loan, causing property foreclosure. Wraparound mortgages require the seller and buyer to trust one another to continue making payments. If Joel continues to make payments to Damon, but Damon stops paying his lender, the property could go into foreclosure. Conversely, if Joel stops paying Damon, and then Damon can’t afford to continue making payments, the same thing could happen.
- Higher interest rates could make wraparound loans less worth it. Wraparound mortgages are usually mutually beneficial for the seller and buyer. The buyer gets a property they could obtain through traditional financing, while the seller earns money by charging a higher interest rate. In some cases, this interest rate may be too high. If Damon wanted to charge Joel 10% instead of 6%, Joel’s monthly payments would cost $750 more ($2,369 as opposed to $1,619, assuming Damon it’s a 30-year fixed rate). It may be more advantageous for Joel to look elsewhere or improve his credit and DTI ratio to get approved for conventional financing eventually.
Alternatives to Wraparound Mortgages
If you’re a prospective home buyer or investor struggling to obtain conventional financing, wraparound mortgages are just one of your many options.
Government-backed loans
Home buyers have three unique options available to them.
- FHA loans: FHA loans allow buyers with lower credit cards to purchase homes with smaller down payments. If you have a credit score of 580 or higher, you can buy a home with three and a half percent down. If your score is 500 – 579, your down payment will need to be upwards of 10%.
- VA loans: VA loans are for veterans, active duty service members, surviving spouses, and others who meet comparable requirements.
- USDA loans: USDA loans are part of a rural development loan program that offers specialized loans based on your zip code and county.
Hard money loans
Hard money loans are short-term loans that use tangible assets as collateral in exchange for financing. These loans have fewer loops than conventional lenders require but have higher interest rates and are usually taken out by investors looking to fix and flip properties. If you default on a hard money loan, you’re putting your collateral at risk.
Private loans
Private loans are loans you receive from someone to purchase an asset—in this case, property. Private lenders can be family members, friends, angel investors, or really anyone with extra cash and an interest in working with you. These loans are even more flexible than hard money loans, but you should pay close attention to their terms before signing anything.
Is a Wraparound Mortgage Worth It?
Wraparound mortgages can be advantageous under certain circumstances, but it all depends on your situation and the terms of your loan. A lot can go wrong with an agreement like this, so you need to be extra certain that the person on the other side of that promissory note is someone you can trust.
If you want to enter into a wraparound mortgage but are struggling to come up with the right terms, start a discussion in the BiggerPockets forums. Our forums give you access to the world’s largest community of real estate professionals, and someone’s always happy to help.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
