What is a Wrap Around Loan and How Does it Work? A Complete Guide for Homebuyers

A wrap around loan is a unique type of mortgage financing that can benefit both home buyers and sellers. As a potential homebuyer it’s important to understand exactly how wrap around loans work so you can decide if this type of financing is right for your situation.

In this comprehensive guide, I’ll explain what a wrap around mortgage is how it works the pros and cons, and examples of when it may make sense to use wrap around financing. Whether you’re a first-time homebuyer or looking to move up to a more expensive property, read on to learn everything you need to know about wrap around home loans.

What is a Wrap Around Mortgage?

A wrap around mortgage is a special type of financing where the home seller provides part of the buyer’s mortgage It allows the seller to keep their existing mortgage on the property while also extending financing to the new buyer Here’s a quick rundown of how it works

• The seller has an existing mortgage on the home with Loan A.
• The home is sold to a new buyer who needs financing.
• Instead of the buyer getting a new mortgage for the full purchase price, the seller gives the buyer a second mortgage, Loan B, to cover the remaining amount needed.
• Loan B wraps around the seller’s original Loan A.
• The buyer makes monthly payments to the seller on Loan B.
• The seller takes part of those payments to make the payments on Loan A.

So in essence, there are two loans – the seller’s original mortgage (Loan A) and the wrap around mortgage given to the buyer (Loan B). The wrap around encircles or “wraps around” the first loan.

This arrangement allows buyers to purchase a home with less financing since the seller’s equity is involved. The seller benefits by earning a higher interest rate on the wrap around loan they provide to the buyer.

How Does a Wrap Around Mortgage Work?

Now that you understand the basic concept, let’s look at the details of how a wrap around mortgage works and the steps involved:

1. Seller has existing mortgage

First, the home seller must have an existing mortgage on the property with a lender. This is Loan A in our example above.

The remaining balance on Loan A will determine the amount needed for the wrap around mortgage (Loan B) provided to the buyer.

2. Original mortgage must be assumable

For a wrap around mortgage to work, the seller’s original mortgage (Loan A) needs to be “assumable.”

This means that the loan terms allow a new buyer to take over or “assume” the mortgage from the seller. Common assumable mortgage types include FHA, VA, and USDA loans.

3. Seller gets lender approval

Before proceeding with a wrap around mortgage, the seller needs to get approval from their existing lender to avoid violating their original mortgage terms.

4. Buyer and seller agree on details

The buyer and seller will negotiate the details of the wrap around loan (Loan B), including the loan amount, interest rate, down payment required, and payment schedule.

5. Promissory note signed

The buyer and seller sign a promissory note that spells out the terms for the wrap around loan provided by the seller.

This functions similarly to the mortgage note a borrower signs with a traditional lender.

6. Buyer makes payments to seller

Once the home sale closes, the buyer makes their monthly mortgage payments directly to the seller instead of a traditional lender.

7. Seller pays original mortgage

The seller takes a portion of the buyer’s payment and uses it to make the monthly payment on the original mortgage (Loan A).

This arrangement continues until the buyer pays off the wrap around loan. At that point, the seller would have to pay off or refinance the remaining balance on Loan A.

Pros and Cons of Wrap Around Mortgages

Wrap around financing has advantages and disadvantages for both home buyers and sellers:

For Home Buyers

Pros:

• Easier to qualify since seller provides financing
• May allow purchase of a more expensive home
• Lower monthly payments possible

Cons:

• Higher interest rate than traditional mortgage
• Risk that seller defaults on underlying mortgage

For Home Sellers

Pros:

• Profit from higher interest rate charged to buyer
• May be able to sell home faster

Cons:

• Take on risk if buyer defaults on payments
• Underlying mortgage may have due-on-sale clause

As you can see, wrap around mortgages involve taking on risks, especially for the seller. But in certain situations, the benefits may outweigh the potential downsides for both parties.

Examples of When a Wrap Around Mortgage May Make Sense

Here are a few examples of situations where a wrap around home loan could be a win-win for buyers and sellers:

• The buyer has less-than-perfect credit or limited finances, so they may not qualify for a conventional bank mortgage. The seller provides wrap around financing at a reasonable interest rate to make the sale.

• The seller has significant equity built up in the home. A wrap around mortgage allows them to leverage it to earn extra monthly income via the interest rate spread while still getting most of their capital out.

• Interest rates have risen significantly since the seller originally bought the home. The existing mortgage has a lower fixed rate. A wrap around structure allows the buyer to benefit from that lower underlying rate.

• The seller needs to sell quickly, such as due to a job relocation. Offering wrap around financing opens the pool of potential buyers.

• The home has unique features that appeal to buyers but also make appraising it for a traditional mortgage difficult. Seller financing helps make the deal work.

Structuring a Secure Wrap Around Mortgage

While a wrap around mortgage can benefit both parties, the risks mean extra precautions should be taken:

• Due diligence on underlying mortgage – The seller should verify that the original loan does not have any provisions that would stop a wrap around mortgage, such as a due-on-sale clause.

• Close review of buyer finances – The seller should carefully assess the buyer’s financials to ensure they can handle the payments. Requiring a sizeable down payment can help reduce risks.

• Ironclad contractual agreement – Detail the obligations, rights, and recourse options in the wrap around loan promissory note and home purchase contracts. Consult attorneys as needed.

• Title insurance – The buyer should purchase title insurance to protect against losses if underlying mortgage issues later surface.

• Reliable payment processing – Using an escrow company to handle payments ensures the seller makes the underlying mortgage payments on time.

Taking these precautions will help minimize the risks for both parties entering a wrap around home loan agreement.

Alternatives to Wrap Around Mortgages

Wrap around mortgages fill a unique niche in home financing situations. But they aren’t the only option for buyers who can’t get traditional bank loans. Some alternatives to explore include:

• FHA loans – Government-backed FHA loans require lower down payments and credit scores as low as 580.

• VA loans – For qualifying military buyers, no down payment is required on VA loans.

• USDA loans – In designated rural areas, USDA mortgages offer favorable terms and require no down payment.

• Family loans – Borrowing from family members may provide more flexible terms compared to seller financing.

• Lease-to-own agreements – Lease the home while rebuilding your finances, then buy it when you qualify for a standard mortgage.

• Investor financing – Hard money loans from investors provide short-term financing for buyers who expect to quickly rebuild their credit.

• Seller concessions – Sellers can pay closing costs or fees to help buyers purchase the home with less cash.

The Bottom Line on Wrap Around Mortgages

A wrap around mortgage involves both risks and rewards for home buyers and sellers. This type of financing is best suited for specific situations where the benefits outweigh the drawbacks for both parties involved.

If you’re considering a wrap around home loan, do your homework upfront to fully understand the pros, cons, and alternatives before moving forward. Careful structuring of the deal can help mitigate risks and make it a win-win arrangement. With the right property, buyer, and seller circumstances, a wrap around mortgage can be an effective way to get a home sold or purchased that otherwise may not happen.