What is a wraparound mortgage?

A wraparound mortgage is a lesser-known, unique financing option in residential real estate. It’s a type of homeowner or seller financing, in which the buyer gets a mortgage that includes the previous owner’s existing loan. The buyer makes monthly payments to the seller, who in turn pays their own mortgage lender — and often pockets a bit of a profit on the difference between the two payments.

It’s far from a conventional loan, but can be an opportunity for both homebuyers struggling to obtain a mortgage and sellers in distress.

How do wraparound mortgages work?

What’s happening technically in a wraparound mortgage: The seller is maintaining their own mortgage and acting as lender to the buyer, extending them the financing to purchase the home. The buyer ‘s mortgage “wraps around” the existing loan the seller has on the property (the amount can be more than the remaining balance of the seller’s mortgage).

Each month, the buyer makes payments to the seller, who then makes their own regular repayments to their lender (who financed the original loan). In many cases, the wraparound mortgage will have a higher interest rate than the existing mortgage, making the buyer’s monthly payments larger than the seller’s. So the seller can cover their payments and also profit.

The buyer and seller both have to agree to the wraparound mortgage, and the seller needs to obtain permission from their lender before moving forward with the transaction.

After the terms are in place and a promissory note signed to seal the deal, the seller might either transfer the home’s title to the buyer right away or transfer the title once the loan is repaid. Once the title is transferred, the buyer is considered the owner of the property.

Wraparound mortgages are in a junior or second lien position on the property. So if the buyer can’t or doesn’t make payments, the original lender — not the seller — would be repaid first from the proceeds of a foreclosure sale. In other words, the lender would benefit before the seller is able to recoup any losses.

Example of a wraparound mortgage

Say a seller has a remaining mortgage balance of $100,000 with an interest rate of 5 percent on a home worth $200,000. The seller finds an interested buyer who is unable to qualify for traditional financing.

To cover their risk, the seller agrees to a wraparound mortgage of $150,000 — including a $10,000 down payment — and an interest rate of 7 percent. The seller is able to pocket the excess $50,000. As they continue to make payments at the 5 percent interest rate, they are also able to make money off the 2 percent difference between their original rate and the new interest rate.

The wraparound mortgage doesn’t have to be greater than the original mortgage: The buyer and seller can agree to a loan that covers only the current principal. Even if the buyer only takes on a loan of $100,000 in this scenario, the seller still profits off the 2 percent rate difference between loans.

Benefits of a wraparound mortgage

Wraparound mortgages can be advantageous for both the buyer and the seller of a home.

Benefits for buyers

• Easier to obtain. “A wraparound mortgage is a good idea when the buyer does not qualify for any mortgage products with lenders,” explains Benjamin Schandelson, a mortgage loan originator and head of marketing with MJS Financial LLC in Boca Raton, Florida.
• Smaller loan. The buyer might also be able to borrow less than if they were buying the property with a loan of their own.
• Simpler, cheaper transaction. Buyers won’t have to wait through a lender’s long underwriting process, and may be spared many mortgage-related closing costs.

Benefits for sellers

• Profit potential. Along with any appreciation in the home price, sellers get to pocket the difference between their remaining mortgage balance and the wraparound mortgage. They also profit from the difference in their loan’s interest rate and the higher one the buyer is paying.
• Enhanced cash flow. The owner gets regular income each month in the form of the buyer’s mortgage payment.
• Selling strategy. Offering a wraparound mortgage might increase interest in the home, attracting buyers who normally might not be able to afford it.

Risks of a wraparound mortgage

Wraparound mortgages aren’t perfect: Both buyers and sellers face some risk.

Risks for buyers

• Unreliable sellers. “The biggest risk is the seller defaulting on the original mortgage, which can put the property the buyer is living in into foreclosure,” says Schandelson. You have to trust that the seller will keep making payments on their mortgage. If they don’t, the lender could seize the home, even if your own payment record is spotless. You also have to trust the mortgage was assumable in the first place; if the seller didn’t get permission for the wraparound, the lender could also foreclose or call the mortgage in.
• More expensive terms. The extra interest the seller is charging you may exceed conventional mortgage rates: They want compensation for their trouble/risk, especially since you might not be the most creditworthy of buyers (otherwise, wouldn’t you be getting a loan of your own?).

Risks for sellers

• Paperwork. Guess what? You’re in the home-financing biz, and all that it implies: Sending out statements/invoices, keeping track of payments, making sure you maintain records and accounting for the income on your tax return. If you don’t properly report it, the IRS will not be happy.
• Unreliable buyers. You need to believe that the buyer will make their required payments on time and in full. After all, you’re still on the hook for your monthly payment, even if the buyer stops paying. “This means you either need to come out of pocket or miss payments, which can hurt your credit score,” says Schandelson. “You might also need to take legal action against the buyer for not paying, which can be costly.”

Alternatives to a wraparound mortgage

Although they can help buyers with poor credit or in high/rising interest-rate environments, wraparound mortgages aren’t the only option. Consider these other possibilities:

• Government-backed loans. These mortgages offer low down payment requirements and are available to borrowers who don’t have great credit scores. FHA loans come with the fewest restrictions. USDA and VA loans offer generous terms; however, you can only get one in an eligible rural area (USDA) or if you are or have been in the military (VA).
• HFA loan. Available solely through state housing finance agencies, these mortgages are geared towards first-time and low-to-moderate income homebuyers. You may be limited in the home’s purchase price and location (has to be within that state).
• Conventional 97 loan: Available through the government-sponsored entity Fannie Mae, this is a conventional mortgage with 3 percent down payment requirement.

Sellers might also consider alternatives, such as:

• Renting. Using the home as an investment property could still bring significant profit with a similar level of risk. You could give tenants long-term leases, or set up a rent-to-own agreement.
• Renovating. If you’re selling because you need more space or want a nicer home, consider trying to expand or renovate your place instead — especially if the fish aren’t biting. Some strategic remodeling will make your home more valuable down the road, too.

Bottom line on wraparound mortgages

A wraparound mortgage is a creative way for a buyer and seller to facilitate a transaction, but there are risks on both sides. Buyers will need to find the right seller who’s willing to work with them: Options might include a seller who’s having a difficult time unloading their home or one who’s facing the consequences of an inability to pay their mortgage. Sellers will need to make sure their lender allows this sort of arrangement.

Before moving forward with a wraparound mortgage, it’s smart to consult with a real estate attorney who can advise on the risks, and make sure agreements are properly drawn up to protect all parties. For example, buyers might want to add a clause that lets them make some of their payment directly to the lender; sellers might want buyers to put a certain sum in escrow, as a cushion if payments get missed.

Additional reporting by T. J. Porter