"Wrap" Your RE Financing

A common challenge associated with seller financing is the seller’s concern for security. Often a sales agreement allows the buyer to make little or no down payment, take over payments on an existing loan, and secure the remainder of the purchase price with a small second mortgage.

However, the seller’s credit is still at risk on the underlying loan, and the small second lien seems risky if, for some reason, the buyer doesn’t make the required payments.

Use a “wrap”

A wrap refers to the security instrument (wraparound mortgage, land contract, or all-inclusive trust deed). When using this technique, the seller agrees to include his or her existing loan in the seller financing provided to the buyer—by wrapping the existing loan into the terms of the new financing agreement. This often-used financing technique offers many advantages.

Improved security

The seller will collect the payments from the buyer on a wraparound note, and then will make the payments on the existing loan while retaining the difference. This method improves the seller’s security by allowing better control of the financing. Should the buyer fail to make the payments on a wraparound mortgage, the seller instantly knows it and can take the necessary steps to protect his or her credit and equity.

Earn interest income

As with all seller financing, offering wraparound financing makes it easier to sell a property quickly—and often at a better price. And there may also be tax advantages to receiving payments over time, rather than all at once. Should the seller wish to convert the equity into cash, a wraparound note is generally more attractive to a note investor than a small traditional second mortgage. However, perhaps the biggest seller benefit is the potential to earn interest income on the money that is still owed on the existing mortgage on the property. This occurs when the interest rate that the seller charges on the wraparound financing exceeds the interest rate due on the underlying financing.

Sale and purchase

For example, let’s say “Miranda” has a property for sale with an existing first mortgage of $180,000 at 6 percent, with monthly payments of $1,100. Eric purchases the property with nothing down on the wraparound note for $200,000 at 7.5 percent— with monthly payments of $1,400 per month. Miranda collects: • 7.5 percent on her equity of $20,000 ($1,500). • 1.5 percent interest on the $180,000 owed to the bank ($2,700).

The extra interest she earns on the underlying financing helps to magnify her return considerably ($1,500 + $2,700 = $4,200 annually—which is a 21 percent return on equity of $20,000).

“Due-on-sale” provision

Most mortgage loans today are written with a due-on-sale clause. This provision typically gives the lender the right to demand payment in full when a property is sold. Although some agents mistakenly assume that a due-on-sale provision renders wraparound financing illegal, it does not. However, the provision does allow a lender to call a loan due if the property is transferred by using a wraparound arrangement.

Experience has shown that banks very rarely exercise their right to call these loans due when a property is sold. Automated loan-servicing centers create little opportunity for the lender to become aware of most property transfers. Furthermore, banks have little to gain by calling a loan due and are usually content to collect the payments and interest as agreed.

Contingency plan

You should always include a contingency plan for such a possibility. Include a provision in the wraparound financing instrument, which will obligate the buyer to refinance the property or to retire the debt, if the due-on-sale clause is exercised. As interest rates rise, wraparounds will provide increased opportunities for savvy investors and sellers alike.

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