Ever wonder what the term “wraparound mortgage” means?
A wraparound mortgage is a kind of alternative financing strategy both real estate investors and traditional homebuyers can use to purchase a property.
As you might be aware, it can sometimes be difficult to secure investment loans to buy rental property. It can become especially difficult if you have your own mortgage to pay, car loan payments, etc. All of these things add up and can hurt your debt to income ratio, making you ineligible for a second mortgage via traditional lenders. Likewise, bad credit can also leave you out of many standard options.
Related: How Many Mortgages Can I Have as a Real Estate Investor?
Luckily, there are plenty of creative real estate financing strategies available to investors who want to work beyond such setbacks. Alternative investment property financing such as a wraparound mortgage loan can help investors make money in real estate despite the challenges.
In this article, we will answer the following questions:
- What is a wraparound mortgage?
- How does a wraparound mortgage work?
- What are the advantages and disadvantages of wraparound financing?
- Are wraparound mortgages legal?
What Is a Wraparound Mortgage?
A wraparound mortgage is a junior loan or second mortgage taken out directly with the seller of a property, as opposed to a bank or traditional lender.
Essentially, the usual loan approval process is skipped, and sellers work with real estate investors to set loan and repayment terms. The buyer is responsible for paying the seller for the full purchase price of the home plus interest over a period of time, as determined by negotiation.
How Does a Wraparound Mortgage Work?
When financing options are scarce, real estate investors can seek an arrangement such as a wraparound mortgage to help them secure a rental property. Though a wraparound mortgage can be explained in very simple terms, investors should be aware that this does not mean the process of securing one is simple. We will talk further about the risks associated with this type of real estate financing later in this article.
In order for a wraparound mortgage to work, a buyer will typically pay the seller a down payment. The buyer will then pay the seller monthly, which will cover the outstanding balance the seller still owes on the property. Additionally, the buyer will continue to pay the seller until they’ve paid the full selling price of the property, plus interest.
Example Financing Scenario:
If the price of a home is $200,000, and a real estate investor wants to secure a wraparound mortgage with the seller, the investor might choose to make a $40,000 down payment.
It is worth noting that the home buyer can make any size down payment (or none at all), as long as the seller agrees to the amount. A seller may require the buyer to make a certain size down payment if they need the cash upfront to purchase another home themselves.
In this case, the remaining balance on the home is $160,000. The buyer will be responsible for paying interest, the rate of which will be agreed upon by the buyer and seller. For this example, we can use $30,000 as the total interest the buyer will be expected to pay. In total, the real estate investor ends up paying $230,000 for the investment property (the purchase price plus interest).
We can take a further look at where this money is applied:
Let’s say the seller still owes $100,000 on their loan. The buyer will make monthly payments that the seller will use to pay off the loan. After the loan is fully paid, the buyer is required to continue making payments to the seller until the remaining balance plus interest is met. For this scenario, after the seller’s loan is paid off, the buyer would still have to pay the additional $60,000 still owed on the $200,000 sales price, plus the $30,000 in interest.
Advantages of Securing a Wrap Loan
The advantages of a wraparound mortgage are fairly compelling to the right investor, though not to every investor.
- The buyer can purchase an investment property with bad credit.
- The buyer can purchase an investment property with a high debt to income ratio.
- The buyer will not have to go through a traditional bank. This speeds up the loan processing time, allowing for faster investment moves.
- The buyer may be able to negotiate a down payment less than the traditional 20%.
Disadvantages to Using a Wrap Loan
As great as this may seem for real estate investors looking for alternative investment loans, it is important to consider the risks associated with securing a wraparound mortgage:
- The seller can default on the original loan or fail to make payments, leading to foreclosure.
- The seller’s mortgage lender might demand full repayment of the loan once the property is sold.
- The seller can demand high interest rates from the buyer.
Related: Real Estate Investment Financing: 7 Ways That Work for Beginners
Are Wraparound Mortgages Legal?
Is a wraparound mortgage legal?
Wraparound mortgages are completely legal. There is nothing legally preventing you from making a deal directly with a seller.
However, it is extremely important for investors and sellers alike to do their homework. While it is legal for sellers and buyers to negotiate wraparound mortgages, it is just as legal for mortgage lenders to demand full repayment of the original loan in many cases.
Sellers should check the legal language surrounding their mortgage before assuming they can make this kind of deal with a buyer. Additionally, real estate investors should double-check for due-on-sale clauses. This can be done by contacting the bank the seller uses, or by hiring an attorney to investigate.
A word of caution to investors: due-on-sale clauses are quite commonly included in most mortgage agreements. It may be difficult to find a situation where a wraparound mortgage is a true possibility. In any case, never take a seller’s word for it; always do your own research.
The Takeaway:
Ultimately, a wraparound mortgage makes for an appealing and potentially helpful investment financing method.
If both parties (seller and buyer) are responsible and hold to the agreement, it can be a mutually beneficial situation. Sellers can make more money from the sale by charging high interest and cutting out the need for real estate agent fees. Investors can seize the opportunity to purchase a rental property when other financing options might not be available. This allows them to make money in real estate sooner.
Investors should be aware of the risks involved in any kind of investment financing before making their decisions. In the case of using a wraparound mortgage, investors should do their research and ensure the seller signs legally binding contracts.
No matter what method of investment financing you use, back up your investment decisions with rental property analysis. To make money in real estate, you must purchase rental properties that have the potential to be lucrative.
Mashvisor helps investors purchase high-income rentals in the right neighborhoods with our state of the art real estate investment software. You can also use our tools to figure out how your interest rate and down payment will affect your return on investment using the mortgage calculator.