As interest rates continue to rise, buyers may begin to search for creative financing alternatives that allow them to maximize their purchasing power and get into the homes of their choice. One option that may reemerge from the days of high interest rates in the mid 1970’s and early 1980’s is the wrap around mortgage. So, what is a wrap around mortgage and what makes it so attractive for buyers and sellers in the face of continued interest rate hikes? 

A wrap around mortgage is a type of Seller financed home loan where the Seller retains and continues to make payments on the original mortgage (“First Priority Mortgage”) using the mortgage payments made by the Buyer to the Seller (“Second Mortgage”) – the Seller of a property acts as the lender (“Third Party Lender”) and the Buyer’s mortgage “wraps around” the Seller’s original mortgage. Contrast this with a traditional real estate transaction, where the Buyer secures a loan from a bank that enables the Buyer to pay the entire purchase price to the Seller at settlement. The Seller then uses these funds to pay off the original mortgage on the property.

To illustrate, let’s say that Sally Seller owns a home valued at $600,000 with $325,000 remaining on her mortgage at an interest rate of 3%. Sally Seller’s current monthly mortgage payment is about $1,370. 

In a traditional real estate transaction, Betty Buyer secures a loan from a lending institution (“Lender”) that allows her to present the full purchase price of $600,000 to Sally Seller at settlement. Sally Seller uses a portion of those funds to pay off the remaining $325,000 on her mortgage and keeps the rest as proceeds, minus any closing costs and agent commissions owed. Betty Buyer’s monthly mortgage payments is paid to the Lender. If the loan Betty Buyer secured is for a 30 year fixed loan in the amount of $580,000 at the prevailing interest rate of 7%, Betty Buyer’s monthly payment to Lender is about $3,859. 

With a wrap around mortgage, however, Sally Seller acts as the third party lender. The terms of this second mortgage agreed upon by the parties are similar to what a traditional lender would offer - a 30 year fixed loan in the amount of $580,000 , but perhaps with an interest rate at 5% which is much lower than the prevailing rate, thanks to the lower interest rate secured in the First Priority Mortgage by Sally Seller. Betty Buyer’s monthly payment to Sally Seller is about $3,114. Sally Seller uses this payment to pay off the first priority mortgage and keeps the difference of $1,744 as profit ($3,114 - $1,370 = $1,744). Once the First Priority Mortgage is paid off, Betty Buyer’s entire monthly payment becomes pure profit for Sally Seller. 

Transactionally a wrap mortgage may be structured such that title passes to the buyer upon execution of the wrap note and deed of trust or title may be transferred at a future point in time utilizing a contract for deed. 

There are both benefits and risks to Buyers and Sellers entering into this kind of arrangement:

On the Buyer side, a wrap around mortgage can allow a Buyer to benefit from the lower interest rate secured by the Seller. It can also allow for Buyers who may not qualify with a traditional lender to obtain financing for their home. That said, in the event payments are not made, Buyer may face the forfeiture of all the equity and payments Buyer has made in the event title did not pass to the Buyer. Alternatively, if title did pass to the Buyer, then the prospect of foreclosure looms as a penalty. Further, if the Seller defaults on the First Priority Mortgage the Seller’s lender may foreclose on the property. Should this occur, the Buyer could lose the property even if their payments to the Seller on the Second Mortgage are current.

On the Seller side, allowing for creative financing options opens up the pool of potential buyers and can increase the affordability of the home by allowing a Buyer to benefit from the Seller’s lower interest rates. This allows the Buyer to offer a higher purchase price than they might otherwise be able to afford. By acting as the lender, the Seller also benefits from the interest payments on the second mortgage. Risks include the Buyer failing to make payments on the Second Mortgage thereby requiring the Seller to foreclose, if title transferred, and if not, retaking possession of the property and continuing to make payments on the First Priority Mortgage.

Sellers should also note that this type of arrangement could violate the Transfer of the Property or Beneficial Interest in Borrower clause of their deed of trust, which allows the lender to require immediate payment in full of all sums secured by its deed of trust. This type of transaction can also create questions regarding the mortgage interest tax deduction and how to procure title and homeowner’s insurance. Accordingly, we recommend that parties seek appropriate counsel before entering into any such agreement to be fully informed of any risks that may exist and ensure they are being mitigated appropriately.