What is a wrap-around loan?
One mortgage loan that may be used in owner-financing transactions is a wrap-around loan. The whole purchase price that must be paid to the seller over time is determined by considering the seller’s mortgage on the property and an extra incremental value.
Understanding Wrap-Around Loans
In seller-financed transactions, the financing a wrap-around loan is based on is often used. Like a seller-financed loan, a wrap-around loan incorporates the seller’s existing mortgage into the financing conditions.
A kind of financing known as seller financing enables the buyer to make a principal payment to the seller directly. Deals involving seller financing carry significant risks for the seller and often require larger than typical down payments. When a transaction is seller-financed, the financing conditions are outlined in a promissory note that forms the basis of the agreement. Furthermore, under a seller-financed contract, the buyer pays principal and interest in installments straight to the seller; there is no need for the principle to be transferred up front. One seller may be hazardous Because they bear the whole default risk associated with wrap-around loans. Additionally, sellers need to ensure that their current mortgage does not include an alienation provision, which would oblige them to pay back the mortgage lending institution in full if the ownership of the collateral is transferred or sold. Most mortgage loans include alienation provisions, which often prohibit wrap-around loan arrangements.
The Workings of a Wrap-Around Loan
Wrap-around loans use the same fundamental architecture as owner-financing but go farther. In an owner-financed transaction, a wrap-around loan arrangement is used when the seller still owes money on the initial mortgage loan secured by the property. To determine the whole purchase price, a wrap-around loan adds an added amount to the seller’s current mortgage, which is still owed at the agreed interest rate.
The conditions of the current mortgage loan determine the seller’s base interest rate on a wrap-around loan. The seller has to break even by earning interest that is at least equal to the interest rate on the loan, which still needs to be paid back. As a result, a seller is free to bargain for the buyer’s interest rate, depending on the conditions they are now offering. To pay off the original mortgage and earn a spread on the sale, the seller will often try to negotiate the highest interest rate.
A wrap-around loan example
Assume Joyce has an outstanding $80,000 mortgage on her house at a fixed interest rate of 4%.
Brian offers to buy her house for $120,000 if she accepts his 10% down payment and borrows the remaining $108,000 at a 7% interest rate.
Joyce makes 7% on $28,000 (the difference between her current debt of $80,000 and her initial purchase price of $108,000) and 3% on the remaining $80,000 mortgage total.
Conclusion
- A wrap-around loan is an owner-financing arrangement in which the property seller keeps an active initial mortgage, which the subsequent buyer partially repays.
- The buyer inks a mortgage with the seller rather than applying for a traditional bank mortgage, and the new loan is now used to pay down the seller’s previous debt.
- Because the seller-financier assumes the default risk for both loans, wrap-around loans may be dangerous.
