One of my favorite creative finance techniques to buy investment real estate is the wraparound mortgage (WRAP).
A wrap is exactly what it sounds like – it’s a mortgage that wraps around an existing mortgage. In a wrap, the seller leaves the existing mortgage in place, sells the property to the buyer and gives the buyer a mortgage on the property that is subordinated to the existing mortgage.
If it sounds complicated it’s because it is complicated – especially of things go wrong.
Let me give you an example of a wrap to make it easier to understand.
The seller’s property is worth $250,000 and has a mortgage with Countrywide for $200,000 at 6% interest. The seller then sells the property to you for $220,000 and gives you a mortgage for $220,000 at 7% interest. The mortgage that the seller gives you is subordinated to the first mortgage held by Countrywide and is recorded as a second mortgage on the property.
- The seller is still responsible to pay Countrywide the monthly payments on the first mortgage of $200,000 at 6%.
- You are responsible to pay the Seller a monthly payment on the second mortgage of $220,000 at 7%.
- This means that you will pay the seller more than the seller pays Countrywide because your mortgage is larger ($220,000) and at a higher interest rate (7%).
The deal is still a good deal for you because you got the property at a discount plus didn’t need to get and pay for a conventional mortgage. There’s no credit process, no loan application, no appraisal and no little or closing costs. Most importantly, the loan doesn’t appear on your credit report as the seller ill not report your repayment history to a credit bureau.
This allows you to purchase more investment real estate and is an excellent creative finance technique.
The deal is good for the seller because the seller has sold the property, created a monthly income stream and a future profit of $20,000 when you resell the house. When you resell the property you will be forced to pay off the first mortgage and the wrap second mortgage in order to pass clear title to the new buyer.
A wrap mortgage also gives the seller more protection than a simple subject to sale as it records the legal instrument (the mortgage) that the seller can use to recover title in the event of default by the buyer.
One important point to consider is that because a wrap mortgage involves the transfer of title to the buyer, the first mortgage holder may have a due on sale clause in its loan agreement with the seller. This means that the lender can accelerate the loan and call the entire loan due and payable. This rarely happens as long as the first mortgage is paid on time but it is a risk. The seller also needs to be careful to update the hazard insurance policy for the property and change all utility and property tax records.
It’s also important to note that if the buyer defaults on the note, it will be necessary for the seller to foreclose in order to regain title to the property. This is more time consuming and costly than a simple eviction.
So why would any seller consider a wrap mortgage?
In a down market it may not be possible for the seller to sell the property with conventional financing. The property may not appraise for the amount of the outstanding mortgage, the house may need fix up work to make it loan compliant or it may simply not attract a qualified buyer.
In a down economy there is no shortage of unqualified buyers, starting with investors. It’s very difficult to get a non-owner occupied loan following the credit meltdown. This means that investors, with good credit scores and solid financials, can’t get finance or can only get with high interest rates and a large down payment.
If the seller is willing to offer a wrap mortgage this will entice investors to buy the property.
About Ross Hair