You don’t hear this one too much anymore because interest rates are so low.
A
wrap mortgage
is where new mortgage debt is “wrapped around” an old one. This also can be called an all-inclusive-trust-deed (AITD), or seller wrap, or subject to (people call it this but it is not exactly correct). the AITD can be recorded with the county to make it official but as you read on you will see why you might want to do the formal AITD filing.
A wrap is different than a formal loan assumption. It is not an
assumption.
Please be aware that you are
not taking over
the seller or underlying loan.
Usually
this tool or technique
is used when interest rates get so high that people can’t afford or qualify for current interest rates.
When do people use this technique?
This happens
when interest rates are very high
like in the very late 1970s and early to mid-1980s. Because mortgage rates hit 17-20%, sellers had to be creative if they wanted to sell their properties in such a high-interest rate, inflationary time, since so few could afford the 17% mortgage payments.
This also happens when the
financial markets crash
and money is tight, the banks don’t want to lend to just anybody so the sellers become the banks – we see this in
commercial properties
especially.
Sometimes it’s used with
hard to finance, awkward, overpriced properties as well.
How does this work:
They sold their properties, DID NOT pay off their current mortgages which most got in the early 1970s or earlier at 4.5% – they then made a new loan for a higher but NOT market rate. They collected a mortgage payment from their buyer and then turned around and paid their loan.
For example:
Seller wants to sell their $500,000 (a pretty penny since they only paid $300,000 for it).
Mr. Seller owes $200,000 on this real estate at a rate of 4.5 %. the mortgage payment on that is $1013.37.
He sells this property to you for the $500,000 gets a down payment of $50,000 and takes back a mortgage for $450,000 at 6% no PMI.
You love this
because as a self-employed business owner you had trouble qualifying for a loan. The seller even offers you interest only for the first 5 years (easier accounting for him, lower payment for you).
Your payment to Mr. Seller is $2250 per month. He gets that from you and then turns around and pays his $1013 mortgage. The rest is interest income.
A lot of sellers do this on their
rental properties
to avoid the capital gains or spread them out. If they sell a rental outright without a 1031 exchange they may owe a lot in taxes.
Wrap:
His loan to you is wrapped around his loan with his bank. Imagine one balloon inside another.
Caveat 1:
If he doesn’t pay his mortgage that bank is first in line to
foreclose
and you are at risk of losing your investment since you won’t be notified till a certified letter from the bank and from the county show up saying the property is in default or in foreclosure. You will have a very short time to come up with the money to pay off the seller’s loan and void foreclosure though I have been able to pull this off several times over my career.
Caveat 2: Due-on-sale clause:
The
risk
of doing a wrap is that the seller sold the property without paying off the loan and may trigger their due-on-sale clause. You might also get something in writing that if the due-on-sale clause gets triggered the seller has the cash to pay off the loan.
Most banks don’t want to foreclose if they are getting regular payments, or if we are in a downturn they don’t want another foreclosure on their books since they have to hold reserves till they get rid of it. Most servicers may not notice cause the payment is still coming from their original borrower. But
buyer beware
as you may be embroiled in the
seller’s foreclosure
and lose your investment.
If you are the buyer, ask your self why the seller is so willing to do a wrap and read their loan documents to make sure they have the right to do this.
Hope this helps! Happy Investing!
Athena Paquette
NMLS 321683
CA DRE 01142629