The Wrap-Around Mortgage-An Investing Tool (with Restrictions) for a Slow Real Estate Market

A 'wrap-around" mortgage is an "old school" financing technique. It isn't as popular as it once was, but it still has definite advantages for the creative real estate investor in a slow market. It also has advantages for buyers facing foreclosure or who have poor credit.

In basic terms, a wrap-around is a loan deal in which you, as the investor, assume responsibility for an existing mortgage. Here's an example:

The Smiths have a $70,000 mortgage on their home. They sell it to you for $100,000. You pay $5,000 down and then borrow $95,000 on a new mortgage that they grant you. This new mortgage "wraps around" their original $70,000 mortgage because there are still payments to be made on the old mortgage.

So, what are the main advantages to you as an investor? The first is leverage. Here's an example to illustrate how you gain leverage with a wrap-around mortgage:

Assume that the Smiths original $70,000 mortgage has an interest rate of 6%. Assume the new $95,000 "purchase money" mortgage has a rate of 8%. The Smith's "equity spread" is $25,000 ($95,000-$70,000) and they will earn 8% on that portion. But, the Smiths also are earning the difference between 8% the Buyer pays on the full amount and 6% they have to pay on the $70,000 underlying loan that remains in place. So, the Smith's total return is a full 8% on the $25,000 and 2% on the 70,000 that they still owe. In fact that 2% return is huge because it is really not their money, they still owe it on the first mortgage.

Question: How would you like to earn 2% on someone else's money?

Answer: All day long!

So, through this strategy, you've taken the existing mortgage's lower interest rate(6%) and leveraged it into a higher yield (8%) for yourself. In addition, you can deduct all interest paid on a yearly basis as well as the real estate tax. Of course, as a shrewd investor, you can also use wrap around mortgages to turn around properties quickly at a profit.

There are advantages for the borrowers as well. Perhaps due to the current lack of sub prime financing, they can't get financing at an acceptable rate so they opt for the wrap-around mortgage method. By choosing this route, they also avoid the hassle of conventional mortgage procedures (closing costs, etc.). And, as mentioned earlier, they may be facing foreclosure, and a wrap-around sale can spare them the embarrassment of being foreclosed upon.

As with any financial tool, there are disadvantages. Wrap-arounds can only be used with assumable mortgages (i.e., existing borrowers can transfer their obligations to qualified house purchasers).

Bad News: As of this writing, there are no loans that can just be assumed without the written permission of the lender.

So, if a mortgage has a "due on sale" clause, and today most do, this means that the existing mortgage can't be assumed without the original lender's permission. The result--the original lender can decide to call the loan. This is perhaps the biggest risk to you as an investor.

I would not recommend that anyone take over a mortgage in this fashion without first getting written permission from the lender to do so. There is essentially a "due on sale jail", despite what the real estate gurus of today may preach. Proceed with extreme caution!

It's also important to remember that the original lender has first legal rights. So, if the home owners fail to make mortgage payments to the original lender, the original lender can initiate foreclosure procedures.

Key Points: Understand the risks of wrap-around mortgages. Understand the legal technicalities completely before ever attempting this kind of transaction. Make sure all parties understand what's involved in the process. Get written permission from the lender or don't do it! Have an attorney or Title Company write all documents carefully with protections for everyone involved.