A wraparound mortgage is a unique financing option that allows a homebuyer to assume the seller’s existing mortgage while obtaining additional financing to cover the remaining purchase price. This alternative form of lending can help buyers with less-than-perfect credit or those seeking to avoid conventional lenders. However, it requires a clear understanding of its mechanics and potential risks. A financial advisor can help you plan for a home purchase and advise you on the right financing options for your situation.
What Is a Wraparound Mortgage?
In a wraparound mortgage or “wrap,” the buyer makes mortgage payments directly to the seller, who continues to make the payments on their original loan. The new mortgage “wraps around” the existing one, encompassing both the remaining balance and the additional funds borrowed.
After a deal is agreed upon, the buyer signs a promissory note – a legal document in which they promise to pay back the loan – and the title to the property is eventually transferred. Although the buyer technically takes ownership of the home, the seller continues to pay off their original mortgage using the monthly payments they receive from the buyer. Those payments include a higher interest rate on the full amount of the wraparound mortgage, leaving the seller with the difference as profit.
For example, a homeowner named Derick is selling his house, which has a remaining mortgage balance of $75,000 at a 5% interest rate. A buyer named Cynthia agrees to purchase the home for $300,000 and has $30,000 for a down payment. She finances the rest of the purchase using a wraparound mortgage with a 7% interest rate. As a result, she pays off the remaining balance on Derick’s existing loan and he pockets the difference between his monthly mortgage payment and Cynthia’s.
When to Use a Wraparound Mortgage
A wraparound mortgage tends to come in handy under specific financial conditions. For instance, when interest rates spike or the economy enters a downturn, this secondary financing option can help buyers who struggle to qualify for a conventional loan. Keep in mind, it’s not a universal remedy, and the effectiveness can fluctuate based on individual financial scenarios.
Wraparound Mortgage vs. Second Mortgage
While wraparound mortgages are considered a type of secondary financing, they’re not the same as second mortgages.
Second mortgages, which tap into your home’s equity, are typically used to pay major expenses like home improvements or new car purchases. A home equity line of credit (HELOC) is a common example of a second mortgage.
Wraparound mortgages, on the other hand, are intended mainly for sellers looking to finance buyers who may have difficulty securing traditional loans – not for homeowners who are looking to use their home equity to fund other purchases.
Like a wrap, a second mortgage often has a higher interest rate than the first. But while wraparound mortgages essentially take the place of an original loan, second mortgages are separate loans and require homeowners to take on an additional monthly payment.
Pros and Cons of a Wraparound Mortgage
Wraparound mortgages offer some obvious advantages and benefits, but they aren’t a panacea. First, here’s a look at some of the notable pros of using a wraparound mortgage:
- Flexible financing: Wraparound mortgages can be more accessible, offering buyers a chance to secure a property when traditional loans might be hard to obtain.
- Lower closing costs: Since wraparound mortgages avoid some of the fees associated with traditional lending, closing costs can be significantly reduced.
- Continuous income: Sellers can benefit from a steady stream of income, as they continue receiving payments from the buyer and earn interest on the existing mortgage.
- Faster sale: Wraparound mortgages can attract more buyers, potentially leading to a quicker sale.
However, there are risks and potential pitfalls associated with wraparound mortgages. Be aware of the following:
- Default risk: If the buyer fails to make payments to the seller, the seller remains responsible for the original mortgage, potentially leading their original lender to foreclose on the property.
- Due-on-sale clause: Sellers must ensure their original mortgage permits wraparound arrangements, as some lenders may invoke a due-on-sale clause, requiring immediate repayment of the loan upon property transfer.
- Equity risk: Buyers should be cautious when the seller’s mortgage interest rate is higher than current market rates, as this could result in higher costs over time.
Alternatives to a Wraparound Mortgage
Wraparound mortgages, though viable under certain circumstances, aren’t the sole solution available. Buyers may also explore conventional mortgages, adjustable-rate mortgages, balloon mortgages or interest-only mortgages. Each alternative mortgage type brings its set of merits and drawbacks, which could fluctuate depending upon the buyer’s credit history, financial standing and the prevailing interest rate trends.
A wraparound mortgage can be a valuable tool for both buyers and sellers, providing an alternative to traditional financing methods. The seller becomes the “bank” and receives monthly payments from the buyer while continuing to make the monthly payments on their original mortgage. Since the buyer agrees to a higher interest rate, the seller can pocket the difference between their monthly mortgage payment and the buyer’s. However, it’s crucial for all parties involved to thoroughly understand the terms, potential risks and legal implications before proceeding.
Home Buying Tips
- Setting a budget is a vital step in the home buying process. Luckily, SmartAsset has a tool designed to help you figure out how much you can afford to spend on a home purchase.
- Real estate agents aren’t the only professionals you can turn to when buying a home. A financial advisor can help you set a budget, put together a down payment and integrate your home into a comprehensive financial plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Photo credit: ©iStock.com/PC Photography, ©iStock.com/fizkes, ©iStock.com/PeopleImages