How to Go from Landlord to Banker with Wrap Mortgages
Owning investment property can be a drag.
Typically, you find yourself wrapped up in the three “T’s” of toilets, tenants and trash, and spending far too much time on managing your investment.
Sometimes, all of that can become too much and you find yourself needing an alternative.
For those who’d like to stay within real estate, there is another option to earn money on property without the headaches of being a landlord – wrap mortgages.
You put yourself in the position of the banker and you don’t have to deal with another clogged toilet!
Here’s the lowdown on how wrap mortgages work:
What is a wrap mortgage?
A wrap around mortgage is a form of seller financing whereby you (the property owner) take the role of banker by offering a mortgage to the buyer of the property.
The term “wraparound” exists where you already have a mortgage on the property, so you’re going to use part of the money from your buyer’s payments to keep making payments on that existing mortgage.
To illustrate an example, let’s say you owe $90,000 on your property and you’re interested in selling it.
You want a sale price of $150,000 and you have a buyer who is willing to pay that amount. The buyer has a down payment of $20,000 leaving $130,000 to be financed.
As the seller, you finance that $130,000 and issue a promissory note that is secured by a purchase money wraparound mortgage, encircling your existing $90,000 bank first lien mortgage.
You then collect payments from the buyer on the $130,000 promissory note, while at the same time, continuing to make payments on the $90,000 mortgage.
Why use wrap mortgages?
Wrap mortgages can have advantages for both buyers and sellers:
Buyers – For buyers who don’t have the best credit, a wrap mortgage can give them access to purchasing a property when perhaps traditional lenders wouldn’t look at them. Depending on the seller, a buyer might also find that they don’t have to go through such an extensive approval process as they do with banks. It’s up to the seller what they need to see to approve the transaction, so buyers can potentially be in their own house a lot more quickly.
Sellers – In a buyer’s market or in a recession period, there are often not as many buyers available who will be approved by traditional lenders. This can mean that properties don’t sell very quickly. A wrap mortgage opens up more possible buyers and can get your property sold faster.
For some landlords, the opportunity to help out a good tenant is also a motivator.
If you’re able to offer them financing, they get into their own property and you don’t have to worry about putting your property up for sale or giving notice to the tenants.
How do sellers make money on wrap mortgages?
For starters, sellers will usually make something on the purchase price of the property, although of course, they have to be prepared to wait for the full amount of the money and receive installments from the buyer.
In offering seller financing though, they are often able to command a higher sale price in return.
Secondly, most sellers will also charge a spread between the original mortgage and the wrap.
For example, let’s say that $90,000 first mortgage has an interest rate of 3.5%, the seller might charge a rate of 5.5% on the wrap mortgage, so that they’re making a little bit on it.
In our example, they make 5.5% on $40,000 and the difference between the 5.5% and 3.5% on $90,000.
Who owns the property?
The title is transferred from the seller to the buyer, however, should the buyer default on payments to the seller, the seller has the right to foreclose on the mortgage.
Of course, the other bonus for the seller is that maintenance of the property and other tenancy issues are no longer your problem.
Should the buyer sell or refinance the property, the seller is entitled to payoff in full of the remaining wrap mortgage.
Note: Some mortgages will have a clause that states they are due on the sale of the property.
If this is the case with your first mortgage on a property, then a wraparound will violate that clause. Loans that are “assumable” (that is, borrowers are able to transfer their obligations), are wrap-able.
At this time, only VA and FHA loans are assumable without the permission of the lender in the US.
It is highly recommended that you consult with a real estate attorney as any “due on sale” clause can cause a wrap mortgage to fall apart, particularly if the lender exercises their right to demand full payment.
What are the risks?
As you can probably gather from the setup of a wrap mortgage, there are risks to both the buyer and the seller.
The primary risk for both is default.
From the seller’s perspective, a buyer might default on their payments which makes the seller unable to meet the original mortgage and may lead to foreclosure by the original lender.
Even if the seller is still paying the original mortgage, if the buyer defaults, the seller will have to go through the associated hassles of foreclosing on the property.
This can be a lengthy, expensive legal process for the seller to deal with.
At the same time, should the buyer default, you’re exposed to similar risks that banks often face.
You still have the security of the property to fall back on, however, you don’t know what condition that property might be left in.
Mortgagee sales are notorious for “as is” properties where disgruntled former owners have removed fittings and done damage.
For the buyer, there is the risk that, even if they’re making all of their scheduled payments, the seller might not be making the payments to the original loan.
Should they default on that loan, the original lender will have a right to foreclose on the property.
There is potential that the buyer doesn’t see a penny back for their efforts.
Another risk to sellers might be termed under “legal issues.”
The one already raised is any “due on sale” clause from the original lender.
Sellers should also bear in mind that when selling for a profit, they may owe taxes on the sale.
It’s also on them to ensure that loan documents have been properly prepared and instigated.
These are all good reasons why sellers and buyers should get good legal advice from a real estate attorney before entering into a wraparound agreement.
Both parties need to go in from a position of being happy with the deal and understanding all associated risks and obligations.
Wrap mortgages can provide benefits to both sellers and buyers.
The seller can find more potential buyers in challenging markets while the buyer may now have access to buying property where they might not otherwise have an option.
From an investment perspective, selling your property under a wrap mortgage can have a few benefits:
- No more hassles associated with being a landlord.
- Potential to command a higher selling price with seller financing.
- Ability to make money by charging a spread on the interest rate.
For both parties, however, there are risks involved. The best thing you can do before entering any such deal is to get good legal advice and be familiar with what is required.