Wraparound financing, also known as a wraparound mortgage or “all-inclusive trust deed,” is a form of secondary financing where a new mortgage encompasses an existing mortgage. Essentially, the buyer obtains a single, larger loan that covers both the outstanding balance on the seller’s original mortgage and the equity the seller wants to receive from the sale. The buyer makes payments on the wraparound mortgage, and the seller, in turn, uses a portion of those payments to service the underlying, pre-existing mortgage.
Here’s a simplified breakdown of how it works:
- The seller has an existing mortgage with a certain interest rate and outstanding balance.
- The buyer and seller agree on a sale price and a wraparound mortgage interest rate, which is typically higher than the interest rate on the seller’s existing mortgage.
- The buyer obtains a new mortgage (the wraparound) that covers the seller’s existing mortgage balance and the seller’s desired equity.
- The buyer makes payments on the wraparound mortgage to the seller.
- The seller then uses a portion of the buyer’s payment to continue making payments on their original mortgage. The seller keeps the remaining portion as profit.
Wraparound financing can be beneficial in certain situations. For the seller, it can be a way to sell a property quickly, especially if the buyer is unable to obtain traditional financing. It also allows the seller to potentially profit from the difference between the wraparound interest rate and the underlying mortgage interest rate. Furthermore, it can provide a steady stream of income. However, the seller bears the risk of the buyer defaulting on the wraparound mortgage. If this happens, the seller is still responsible for making payments on their original mortgage.
For the buyer, wraparound financing can provide an opportunity to purchase a property when traditional financing is difficult to secure. It might be attractive if the buyer has credit issues or limited down payment funds. However, the buyer typically pays a higher interest rate than they would with a traditional mortgage. There’s also a risk that the seller might not make payments on the underlying mortgage, potentially leading to foreclosure, even if the buyer is current on their wraparound payments. Therefore, due diligence is crucial.
Potential Risks and Considerations:
- “Due-on-Sale” Clause: Many mortgages contain a “due-on-sale” clause, which allows the lender to demand full repayment of the loan if the property is sold or transferred. Engaging in wraparound financing without the lender’s knowledge could trigger this clause.
- Credit Risk for the Seller: As mentioned, the seller is ultimately responsible for the underlying mortgage.
- Complexity: Wraparound financing involves more complexity than a traditional mortgage and requires careful documentation and legal review.
- Higher Interest Rates: Buyers typically pay a higher interest rate on a wraparound mortgage compared to a traditional loan.
In conclusion, wraparound financing can be a viable option for both buyers and sellers in specific circumstances, but it’s essential to understand the risks and complexities involved. Consulting with a real estate attorney and a qualified financial advisor is highly recommended before entering into a wraparound mortgage agreement to ensure a clear understanding of the terms and potential consequences.
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