A wraparound mortgage is a type of seller financing whereby the buyer executes an installment note which "wraps around" an existing mortgage still held by the seller.
Sounds confusing, doesn’t it?
Let's use an example. In the spirit of keeping things simple, I am not going to include things like down payments, commissions, and other expenses involved in a typical transaction.
Let’s say that Buyer Bill wants to buy a home from Seller Sam.
The two of them agree that the house is worth $200,000.
Sam has an existing mortgage that has $40,000 left on it.
$200,000 is what you want to be the sale price to be.
So normally what would happen is Bill would go to the bank and say "I need $200,000".
So, Bill says, "I need $200,000", so he can buy this house from Sam.
Sam would take that money and pay off his mortgage.
But let's say that there is some issue preventing Bill from getting the money from the bank.
Sam can lend Bill this money.
Sam can say, “I like you, and I want to sell my house. How about you make payments to me based on the two hundred thousand plus some interest, much like you would have done with the bank.”
Sam would convey title of the home to Bill and extend a mortgage.
Sam is giving a loan of $200,000, and they agree to an 8% interest rate.
Why would Sam do this?
Maybe Sam was having a hard time getting the price he wants.
Maybe it is not a good market for people like Bill to get credit.
Maybe interest rates are quickly rising.
Maybe time is an issue and they want things to go faster.
Also remember, Sam has an existing mortgage of $40,000.
Let's say that that $40,000 mortgage is at a 7% interest rate.
Sam is continuing to pay his mortgage—he is not going to terminate his mortgage, as he does not have $40,000 to just pay this off because Bill is making payments to Sam as opposed to giving him a lump sum.
Sam originally had his 7% interest rate, and now he is getting 8% interest from Bill.
So he has got a spread because he is still making payments on his existing mortgage. Bill's mortgage to Sam is going to WRAP AROUND Sam’s existing mortgage.
Now Sam is also getting the benefit paying 7% on his mortgage and collecting 8% on the money he lent to Bill.
Bill now has got financing from Sam, so that he can afford the new house. Sam gets to make this spread on his existing mortgage, and Sam gets the price he wanted.
It is a win-win, right?
Not so fast.
Keep in mind that there is a lot of risk for Sam.
This has to be assumable and not have a due on sale clause.
Due on sale clause means that when you convey title, the bank has the right to demand payment immediately.
And the most obvious problem is that Sam runs the risk of Bill not making payments.
If Bill does not make payments to Sam, Sam is not going to be able to pay the existing mortgage.
The bank gets angry, and it is a big issue.
That is a very simple gist of a wraparound mortgage using very simple numbers.