The wraparound mortgage is an excellent and perfectly legal way for investors and homeowners to sell their properties faster and for more money than by selling for cash only. It’s also a great way for realtors to get their listings sold before they expire and avoid losing their commissions.
The traditional, “garden-variety” house sale works like this: Sam Seller owns a house. He’d like to sell it for $210,000. He owes $160,000 on his first mortgage (deed of trust in Texas) to Big Bank. Sam puts his house on the market, either with a realtor or FSBO (For Sale By Owner). Bill Buyer comes along and wants to buy Sam’s house, and they agree on a purchase price of $200,000. Bill puts down some earnest money, they sign a contract, and then Bill applies for a new mortgage from Bigger Bank. Bigger Bank checks Bill’s credit, asks for his tax returns, pay stubs, and a pint of blood, and makes Bill pay for a new appraisal, a new survey, loan fees, underwriting fees, fee fees, etc. At closing, Bill pays Sam a down payment and Bigger Bank pays off Big Bank’s mortgage, Sam’s realtor, the title company, etc., before giving Sam whatever is left over. Big Bank’s mortgage is paid off completely and goes away when Big Bank files a ‘release of lien’ in the county records. Bill now owns the house and Bigger Bank has a first position lien on the house with the new mortgage.
The wraparound mortgage works a little differently. Remember, Sam Seller owes $160,000 on his mortgage with Big Bank. Sam enters into a contract to sell his house to Bill Buyer for $210,000. But this time, Bill does not apply for a new mortgage with Big Bank. Instead, Sam acts as Bill’s bank and mortgage lender. At closing, Bill pays Sam a $21,000 down payment (10%) and gives Sam a promissory note for the balance of the purchase price ($189,000), plus a deed of trust or wraparound mortgage securing Sam’s lien against the property. Sam gives Bill a deed, so Bill now owns the property, but Sam does not pay off Big Bank. Instead, Bill pays Sam every month, and then Sam pays Big Bank out of what he receives from Bill. Bill’s new debt has “wrapped around” Sam’s old debt – hence the name. (“Hence the name” is a phrase that should be used more often, in my opinion.)
This arrangement – Bill pays Sam, Sam pays Big Bank – can continue indefinitely, with Sam getting monthly cash flow from the spread between his payment to Big Bank and Bill’s payment to him. If Bill and Sam agree, they can include a balloon payment in Bill’s note, so that Bill will need to re-finance or re-sell the house within a certain time, usually 3-5 years. When that happens, Bill will pay off his note to Sam and Sam will pay off his note to Big Bank, and the new loan will take a new first position lien on the property. But until Bill sells the property or refinances, there will be two mortgages on the property – Sam’s mortgage with Big Bank and Bill’s mortgage with Sam.
What are the advantages of the wraparound mortgage? Well, for Sam Seller, he gets a cash down payment at closing, monthly cash flow for as long as both mortgages are in place, and another cash payment when Bill Buyer re-finances in a few years. He also gets a better price, better terms and a quicker closing for his sale, because he doesn’t have to wait for Big Bank to process the loan, do the appraisal, etc. And if he sells with 10% down, he can still pay his realtor commissions and keep everybody happy.
Bill Buyer also gets the advantage of a quick closing, and he doesn’t have to go through the lengthy loan application process, credit check, etc. If Bill has some credit issues or other reasons why he wouldn’t be able to qualify for a new mortgage loan right now, he can still buy a house now and have a couple of years to get his credit issues straightened out.
Now, it is true that selling a house on a wrap usually violates triggers the due-on-sale clause in the original deed of trust. That clause, which is included in almost every deed of trust, says that if the seller conveys the property without paying off the first note, then the lender can accelerate the note and call it due. It is not necessarily a violation of, or a default under, the deed of trust, and it is absolutely not “illegal” to do this type of transaction. It is simply a clause that gives the lender the right, but not the obligation, to call the note due.
It is true that this is a risk for both seller and buyer in this type of transaction. But how great a risk? Banks are not in the business of foreclosing on houses and owning real estate. Banks are in the business of making loans and getting paid back. As long as the payments remain current, what incentive does the bank have to accelerate the note? They have enough non-performing loans to worry about, why would they care about one that was being paid on time? As a practical matter, banks almost never “call notes due” based on the due-on-sale clause as long as they are still getting paid. In fact, I have never even heard of it happening if there were no other violations of the mortgage or other issues with the note.
It is a minuscule risk, but it is an actual risk and one that should be disclosed to everyone – the seller, the buyer, the title company, even the lender itself. And Texas law requires a notice to the lender and the buyer if a property is being sold on a wrap and no one is buying title insurance. For more on that particular issue, click here.
With more and more buyers having trouble getting financed for a traditional bank loan, seller financing in general and wraparound mortgages in particular will become more and more common. You can click here to download all the contracts and forms you need to sell your house on a wraparound mortgage, or you can click here to contact me.