What is a Wraparound Loan? A Complete Guide

A wraparound mortgage is an unusual and complex type of financing that involves the seller “wrapping” a new loan around their existing mortgage. If you’re wondering what exactly a wraparound loan is this guide will explain how it works and the pros and cons to consider.

Wraparound Loan Overview

A wraparound loan is a creative financing arrangement that allows a home seller to provide financing directly to the buyer. Here’s a quick rundown of how it works

• The seller has an existing mortgage on the home.

• Instead of the buyer getting a new mortgage, the seller issues them a wraparound loan.

• The wraparound loan wraps around and covers the seller’s existing mortgage.

• The buyer makes payments to the seller, who uses those funds to pay their underlying mortgage.

So in a nutshell, the seller acts as the lender for the buyer, wrapping the buyer’s loan around their own mortgage that remains in place.

How Does a Wraparound Loan Work?

To understand wraparound loans, it helps to walk through a step-by-step example:

1. Seller has mortgage: John has a home with an outstanding mortgage balance of $100,000 at 4% interest.

2. Buyer needs financing: Amy wants to buy John’s home for $150,000 but needs seller financing to purchase it.

3. Wraparound loan created: John issues Amy a wraparound mortgage for $150,000 at 6% interest instead of Amy getting a conventional loan.

4. Buyer makes payments to seller: Amy makes her monthly payments on the $150,000 loan to John.

5. Seller pays underlying mortgage: John uses Amy’s payments to continue paying down his existing $100,000 mortgage at 4%.

6. Seller keeps the difference: Since Amy’s rate is 6% and John’s rate is 4%, John earns a 2% profit on the $100,000 underlying mortgage.

So in essence, the seller acts as the bank for the buyer. This provides financing for the buyer while allowing the seller to earn interest on their existing mortgage.

Wraparound Loan vs Traditional Mortgage

How does a wraparound loan differ from a standard mortgage from a bank? There are some key differences:

• The loan is issued by the seller rather than a bank.

• The terms are set by the seller based on their existing mortgage.

• The buyer repays the loan directly to the seller each month.

• The seller continues paying down their own mortgage.

• The seller keeps any interest rate spread as profit.

So instead of two separate mortgages, the seller combines them into one wraparound structure. This facilitates the sale while keeping their existing mortgage intact.

Benefits of Wraparound Loans

Wraparound loans offer certain benefits for both sellers and buyers:

For sellers:

• Earn interest rate spread as profit
• Access larger buyer pool by offering financing
• Avoid mortgage prepayment penalties
• Retain control until buyer pays loan in full

For buyers:

• Gain access to financing they may not qualify for otherwise
• Potentially avoid extra fees from a traditional lender
• May negotiate more favorable terms than conventional loan
• Simplified loan with one set of payments to seller

When used appropriately, a wraparound mortgage can be a win-win for both parties.

Risks of Wraparound Loans

However, wraparound loans also come with substantial risks that need to be considered:

• Most mortgages prohibit wraparound structures.
• If seller defaults, buyer could lose the home.
• Seller must diligently manage payments.
• Seller has little recourse if buyer defaults.
• Loan terms are set by seller, not lender.
• Higher interest rate than conventional loan likely.

As you can see, the risks fall primarily on the seller acting as lender. So both parties need to fully understand the pitfalls before agreeing to a wraparound arrangement.

Is a Wraparound Loan a Second Mortgage?

While they may sound similar, a wraparound loan is not the same as a second mortgage or junior lien. With a junior lien, there are two totally separate mortgages:

• The seller has their first mortgage loan with a bank.

• The buyer takes out a second mortgage loan on the property.

So there are two distinct loans with two different lenders.

With a wraparound structure, the seller combines both loans into a single wraparound mortgage that wraps the buyer’s loan around the seller’s existing first mortgage.

Wraparound Loan Requirements

For a wraparound loan to work, there are certain requirements:

• The seller’s existing mortgage must be assumable or transferable. Most mortgages today are not.

• The property can’t have any liens or claims on it besides the seller’s mortgage.

• The buyer must qualify based on the seller’s specified loan terms.

• The purchase price must be high enough for the seller to profit from the interest rate spread.

• The seller must diligently manage the loan payments and underlying mortgage.

These criteria make successfully executing a wraparound mortgage difficult. That’s why they are relatively uncommon compared to standard mortgages.

How to Qualify for a Wraparound Loan

Qualifying for a wraparound loan is different than a conventional mortgage since the seller sets the terms. Here are some tips:

• Have a down payment – Most sellers will require 10-20% down to mitigate risk.

• Show you can handle payments – Providing tax returns and bank statements helps prove you can make the monthly payments.

• Get preapproved – Run the numbers with the seller so you both agree you can qualify based on the proposed loan details.

• Have a backup plan – If the wraparound structure ends up not working, have a Plan B for alternative financing.

The keys are making a solid down payment, proving your ability to handle the proposed monthly payments, and getting preapproved by the seller before finalizing the wraparound deal.

Wraparound Loan Interest Rates

Wraparound loan interest rates tend to be higher than rates on conventional mortgages. For example:

• The seller’s underlying first mortgage rate: 4%

• Wraparound loan interest rate to buyer: 6-8%

This allows the seller to profit from the difference between the two interest rates.

Exactly how much higher the buyer’s interest rate is depends on factors like the seller’s existing rate, the purchase price, how much profit the seller wants to earn, and prevailing mortgage rates.

The buyer may be able to negotiate a lower rate than the seller initially proposes by taking key steps like agreeing to a larger down payment. But the rate will still likely exceed standard mortgage rates.

How to Calculate Wraparound Loan Payments

Calculating the monthly payment due on a wraparound mortgage is based on the following factors:

• Purchase price
• Down payment amount
• Interest rate
• Amortization term

You take the purchase price minus the down payment to get the loan amount. Then use a loan payment calculator to determine the monthly payment based on the rate and term.

For example:

• Purchase price: $200,000
• Down payment: 20% ($40,000)
• Loan amount: $160,000
• Interest rate: 7%
• Term: 30 years

Monthly payment = $1,021

The buyer would pay the seller $1,021 per month on the wraparound mortgage.

Pros and Cons of Wraparound Loans

Wraparound mortgages have advantages and disadvantages for both home buyers and sellers:

Pros for Buyers

• Easier to qualify than conventional mortgage
• Potentially lower fees than traditional lender
• Negotiable terms with seller

Cons for Buyers

• Higher interest rate than conventional loan
• Risk of seller defaulting on underlying mortgage
• Loss of rate/term control compared to working with regulated lender

Pros for Sellers

• Profit from interest rate spread
• Access larger buyer pool by offering financing
• Avoid prepayment penalties on first mortgage

Cons for Sellers

• Assume default risk on entire loan amount
• Lose control if buyer defaults and property forecloses
• Loan violates most mortgage contracts, risking calling in full mortgage amount

As you can see, wraparound loans come with considerable risks that require careful evaluation. They should not be entered into lightly by either sellers or buyers.

Alternatives to Wraparound Mortgages

If a wraparound loan seems too risky or complicated, here are some alternatives to consider instead:

• Traditional mortgage – The standard route for buyers to get approved for financing based on income, credit, and down payment.

• Seller financing – The seller finances a portion directly but buyer must get separate first mortgage for the balance.

• Assumable mortgage – The buyer takes over the seller’s existing mortgage loan rather than requiring a new loan.

• Lease-option – The buyer leases the home initially but has the option to purchase it within a specified timeframe.

• Rent-to-own – The buyer rents the home for a set period with the intent of buying it when the lease ends.

Each option has its own pros and cons to weigh when a wraparound loan may not be feasible or sufficiently low risk.

The Bottom Line

A wraparound loan allows creative financing by having the seller essentially combine their mortgage with a new loan to the buyer. But significant risks mean wraparound structures should be approached with extreme care and professional guidance. For most home buyers, a conventional mortgage with a regulated lender is a much safer route.