The wraparound mortgage is a tool used for expidited low-cost real estate sales. The traditional, “garden-variety” house sale works like this: Susan Seller owns a house. She’d like to sell it for $200,000. She owes $110,000 onher first mortgage to Bank 1. Susan puts her house on the market, either with a realtor or FSBO (For Sale By Owner). Bill Buyer comes along and wants to buy Susan’s house, and they agree on a purchase price of $200,000. Bill puts down some earnest money, they sign a contract, and then Bill applies for a new mortgage from Bank 2. Bank 2 checks Bill’s credit, asks for his tax returns, pay stubs, and a pint of blood, and makes Bill pay for a new appraisal, a new survey, loan fees, underwriting fees, fee fees, etc. At closing, Bill pays Susan a down payment and Bank 2 pays off Bank 1’s mortgage, Susan’s realtor, the title company, etc., before giving Susan whatever is left over. Bank 1’s mortgage is paid off completely and goes away when Bank 1 files a ‘release of lien’ in the county records. Bill now owns the house and Bank 2 has a first position lien on the house with the new mortgage.
The wraparound mortgage works a little differently.
Remember, Susan Seller owes $110,000 on his mortgage with Bank 1. Susan enters into a contract to sell her house to Bill Buyer for $200,000. But this time, Bill does not apply for a new mortgage with Bank 2. Instead, Susan acts as Bill’s bank and mortgage lender. At closing, Bill pays Susan a $20,000 down payment (10%) and gives Susan a promissory note for the balance of the purchase price ($190,000), plus a deed of trust or wraparound mortgage securing Susan’s lien against the property. Susan gives Bill a deed, so Bill now owns the property, but Susan does not pay off Bank 1. Instead, Bill pays Susan every month, and then Susan pays Bank 1 out of what she receives from Bill. Bill’s new debt has “wrapped around” Susan’s old debt – hence the name.
This arrangement – Bill pays Susan, Susan pays Bank 1– can continue indefinitely, with Susan getting monthly cash flow from the spread between her payment to Bank 1 and Bill’s payment to him. If Bill and Sausan agree, they can include a balloon payment in Bill’s note, so that Bill will need to re-finance or re-sell the house within a certain time, usually 3-5 years. When that happens, Bill will pay off his note to Susan and Susan will pay off his note to Bank 1, and the new loan will take a new first position lien on the property. But until Bill sells the property or refinances, there will be two mortgages on the property – Susan’s mortgage with Bank 1 and Bill’s mortgage with Susan herself.
What are the advantages of the wraparound mortgage? Well, for Susan Seller, she gets a cash down payment at closing, monthly cash flow for as long as both mortgages are in place, and another cash payment when Bill Buyer re-finances in a few years. He also gets a better price, better terms and a quicker closing for his sale, because he doesn’t have to wait for Bank 2 to process the loan, do the appraisal, etc. And if she sells with 10% down, she can still pay her realtor commissions and keep everybody happy.
Bill Buyer also gets the advantage of a quick closing, and he doesn’t have to go through the lengthy loan application process, credit check, etc. If Bill has some credit issues or other reasons why he wouldn’t be able to qualify for a new mortgage loan right now, he can still buy a house now and have a couple of years to get his credit issues straightened out.
Now, it is true that selling a house on a wrap usually violates triggers the due-on-sale clause in the original deed of trust. That clause, which is included in almost every deed of trust, says that if the seller conveys the property without paying off the first note, then the lender can accelerate the note and call it due. It is not necessarily a violation of, or a default under, the deed of trust, and it is absolutely not “illegal” to do this type of transaction. It is simply a clause that gives the lender the right, but not the obligation, to call the note due.
It is true that this is a risk for both seller and buyer in this type of transaction. But how great a risk? Banks are not in the business of foreclosing on houses and owning real estate. Banks are in the business of making loans and getting paid back. As long as the payments remain current, what incentive does the bank have to accelerate the note? They have enough non-performing loans to worry about, why would they care about one that was being paid on time? As a practical matter, banks almost never “call notes due” based on the due-on-sale clause as long as they are still getting paid. In fact, I have never even heard of it happening if there were no other violations of the mortgage or other issues with the note.
It is a minuscule risk, but it is an actual risk and one that should be disclosed to everyone – the seller, the buyer, the title company, even the lender itself. And Minnesota law requires a notice to the lender and the buyer if a property is being sold on a wrap and no one is buying title insurance.
With more and more buyers having trouble getting financed for a traditional bank loan, seller financing in general and wraparound mortgages in particular will become more and more common.