Today’s housing market is a homeowner’s dream scenario. Between record low interest rates over the past year and the high demand for housing, sellers across the U.S. are typically able to find buyers quickly, often with offers well above the asking price.
But that hasn’t always been the case. During periods when interest rates are high and housing demand is low, homeowners may struggle to find a buyer. In this instance, homeowners have the option of offering a wraparound mortgage to entice buyers.
A wraparound mortgage is a type of seller financing offered by homeowners which features a below-market interest rate. This type of mortgage can also be a way for a seller to provide financing to a borrower whose credit score doesn’t allow them to obtain traditional financing.
Wraparound financing isn’t as common in today’s market, but it’s useful to understand how it works, as you may one day find yourself in a situation where it makes sense for you.
What Is a Wraparound Mortgage?
In the case of a wraparound mortgage, the seller maintains their original loan and allows the buyer to wrap seller financing around it. The buyer makes payments directly to the seller, who then uses part of the money to make their original mortgage payment.
“A wraparound mortgage was widely used back in the early 1980s when interest rates were well into double digits,” said Jill Underwood, a mortgage loan officer based in Lee’s Summit, Missouri. “It basically takes the existing mortgage on a property, which potentially has an interest rate below current market rates, and allows the new home buyer to assume that mortgage at a slightly higher rate, but still lower than the current market.”
How Does Wraparound Financing Work?
A wraparound mortgage is an arrangement where seller financing acts as a junior loan that wraps around the original loan. One unique feature about this type of mortgage is that while the seller is no longer listed as an owner of the home, they do remain on the original mortgage.
“This type of loan differs from other seller financing because it includes the seller’s remaining balance due from the first mortgage into a new mortgage payment,” said Brian Walsh, senior manager and certified financial planner at SoFi, an online lending platform.
Let’s put this into real-life context. Suppose Jan owns a home worth $200,000, and her original mortgage has a remaining balance of $50,000 and an interest rate of 4%. Instead of the buyer getting a $200,000 loan from a bank to purchase the home, Jan herself might finance the loan at an interest rate of 6%. Jan’s loan to the buyer is the wraparound mortgage — and it’s wrapping around Jan’s original loan.
Wraparound mortgages are most beneficial when interest rates are high and buyers can use this type of seller financing to get a below-market rate. In today’s low-rate environment, there are likely more attractive options.
Each month, the new homeowner will make a mortgage payment directly to Jan, who continues to make her monthly mortgage payments. Jan keeps the difference between what the buyer pays her and what she owes the lender. The interest rate spread of 2% serves as profit for Jan for financing the wraparound mortgage.
Wraparound Mortgage Risks and Benefits
Before pursuing a wraparound mortgage, it’s important to fully understand the pros and cons of the situation. There are benefits to both the buyer and seller in this type of transaction, but there are also some risks.
Risk and Benefits for the Buyer
The primary benefit of a wraparound mortgage for a buyer is that it allows them to get financing that might not otherwise be possible. A buyer with a poor credit history may struggle to get a loan, and a wraparound mortgage offers an alternative form of financing.
There are also risks involved for buyers. Unlike traditional mortgage financing, a wraparound mortgage means the previous owner is still responsible for making payments to the original mortgage lender. As a buyer, one major risk you take is the seller potentially stopping those payments and you losing your home.
There are certain questions you should ask before embarking on wraparound mortgage financing. “What happens if the buyer of the property and the seller who owns the wraparound mortgage doesn’t make their payments?” said Melissa Cohn, an executive mortgage banker at William Raveis Mortgage, a mortgage lender and broker in Shelton, CT. “Are you at risk of having the underlying loan foreclosed upon and losing your property?”
One way to mitigate this risk could be an arrangement to make payments directly to the original lender. This would have to be agreed upon in the loan agreement.
“It’s important for homebuyers to remember that a wraparound loan is a junior mortgage, meaning any senior claims will take priority,” said Walsh. “Buyers should make sure they understand all the risks of entering this type of secondary and owner financing, including what would happen in the worst-case scenario such as a foreclosure.”
Buyers should also consider the interest rate they’re paying for the wraparound mortgage. These loans are most useful in high interest rate environments when buyers can save money with a wraparound loan. In today’s low-rate environment, they aren’t as beneficial.
“In general, as a borrower, you want to make sure you’re not going to end up paying an above-market rate because someone is offering you a wraparound mortgage,” said Cohn.
Risk and Benefits for the Seller
Wraparound mortgages can be beneficial for sellers for several reasons. First, they give sellers the opportunity to make a profit, since they’re pocketing the difference between the loan’s original interest rate and the wraparound loan rate.
These loans can also help sellers find buyers in difficult markets. They are attractive to buyers when interest rates are high because the seller can offer wraparound financing at a rate lower than the current market rate. A wraparound mortgage can also help a seller finalize a deal if the only interested buyer can’t get traditional financing.
But the seller is also taking on some risk as well because they are relying on the buyer to make their monthly mortgage payments. Though the seller doesn’t technically own the home anymore, they do have an outstanding mortgage and risk damaging their credit if loan payments aren’t made. If the buyer stops paying, the seller must choose between using their own money to make payments on behalf of the buyer or having their credit take a hit, which is less than ideal.
Sellers should also be aware of the market and when wraparound mortgages are especially useful. In the current seller’s market, homeowners are having an easy time finding buyers, and often are able to sell their homes for more than the asking price. As a result, there is likely little incentive to entice buyers with seller financing.
A wraparound mortgage is a type of non-traditional financing in which a home seller allows the buyer to continue to pay the home’s existing mortgage while wrapping another loan around it. This mortgage is useful in high interest rate environments when a buyer may be struggling to find suitable financing, and comes with benefits and risks to both the buyer and seller.