What Is a Wrap-Around Loan?
A wrap-around loan is a type of mortgage loan that can be used in owner-financing deals. This type of loan involves the seller’s mortgage on the home and adds an additional incremental value to arrive at the total purchase price that must be paid to the seller over time.
- A wrap-around loan is a form of owner-financing where the seller of a property maintains an outstanding first mortgage that is then repaid in part by the new buyer.
- Instead of applying for a conventional bank mortgage, the buyer signs a mortgage with the seller and the new loan is not used to pay off the seller's existing loan.
- Wrap-around loans can be risky due to the fact that the seller-financier takes on the full default risk associated with both loans.
Understanding Wrap-Around Loans
The form of financing that a wrap-around loan relies on is commonly used in seller-financed deals. A wrap-around loan takes on the same characteristics as a seller-financed loan, but it factors a seller’s current mortgage into the financing terms.
Seller financing is a type of financing that allows the buyer to pay a principal amount directly to the seller. Seller financing deals have high risks for the seller and usually require higher-than-average down payments. In a seller-financed deal, the agreement is based upon a promissory note that details the terms of the financing. In addition, a seller-financed deal doesn't require that principal be exchanged upfront, and the buyer makes installment payments directly to the seller, which include principal and interest.
Wrap-around loans can be risky for sellers since they take on the full default risk on the loan. Sellers must also be sure that their existing mortgage does not include an alienation clause, which requires them to repay the mortgage lending institution in full if collateral ownership is transferred or if the collateral is sold. Alienation clauses are common in most mortgage loans, which often prevent wrap-around loan deals from occurring.
How a Wrap-Around Loan Works
Wrap-around loans build on the owner-financing concept and deploy the same basic structuring. A wrap-around loan structure is used in an owner-financed deal when a seller has a remaining balance to pay on the property’s first mortgage loan. A wrap-around loan takes into account the remaining balance on the seller’s existing mortgage at its contracted mortgage rate and adds an incremental balance to arrive at the total purchase price.
In a wrap-around loan, the seller’s base rate of interest is based on the terms of the existing mortgage loan. To break even, the seller must at least earn interest that matches the rate on the loan, which still must be repaid. Thus, a seller has the flexibility to negotiate the buyer’s interest rate based on their current terms. Generally, the seller will want to negotiate the highest possible interest rate in order to make payments on the first mortgage and also earn a spread on the deal.
Example of a Wrap-Around Loan
Let's say that Joyce has an $80,000 mortgage outstanding on her home with a fixed interest rate of 4%.
She agrees to sell her home to Brian for $120,000, who puts 10% down and borrows the remainder, or $108,000, at a rate of 7%.
Joyce earns 7% on $28,000 (the difference between $108,000 and the $80,000 she still owes), plus the difference between 7% and 4% (i.e. 3%) on the balance of $80,000 mortgage.