What is a wrap-around mortgage?

"I thought I'd be stuck renting forever until my realtor suggested a wrap-around mortgage."

If homeownership seems out of reach, a wrap-around mortgage may offer an unconventional path to being able to buy your own place.

This unique financing structure allows you to wrap an existing mortgage into a new loan.

Essentially, you take over the seller's mortgage payments instead of getting your own traditional loan.

Wrap-around mortgages open up home buying possibilities, especially for those who can't qualify for standard mortgages. But they come with some drawbacks and risks that you should know about.

In this guide, you'll learn:

• what a wrap-around mortgage is and how it works
• the pros and cons of wrap-around mortgage financing
• who should (and shouldn't) use a wrap-around mortgage
• alternatives to explore before pursuing this route

To help you make an informed decision about whether a wrap-around mortgage suits your home buying needs and financial situation, keep reading.

What is a wrap-around mortgage?

A wrap-around mortgage (also known as a “wrap”) essentially wraps an existing first mortgage into a new, larger mortgage with a higher interest rate.

Instead of the buyer getting their own traditional mortgage, the seller retains their original first mortgage.

But now, the buyer makes payments to the seller that cover the sum of the seller’s existing first mortgage payment and the principal and interest on the new wrap mortgage.

This relieves the buyer from having to qualify for and obtain a new mortgage. And the seller holds the deed until the wrap-around mortgage is paid off.

Here's an example of how wrap-around mortgage financing works in real estate transactions:

• Mary buys a $300,000 house from Sam.
• Sam has an existing mortgage with a balance of $180,000, a 6% interest rate, and 15 more years of payments.
• Mary pays Sam $30,000, or 10%, as a down payment and rather than getting a new first mortgage, she and Sam agree to a wrap-around for $270,000 at 7% interest over a 30-year term.
• Every month, Mary sends Sam a payment that covers the principal and interest on the new wrap mortgage.
• Sam continues to make payments toward his original mortgage and pockets the additional amount, which goes toward paying down the balance on the wrap mortgage.

When the wrap-around mortgage has been paid off, Sam pays off his original first mortgage loan.

This arrangement allows Mary to buy the home through unique seller financing without having to qualify for a traditional bank mortgage.

Wrap-around mortgages require only a down payment to the seller. The seller holds the deed and underlying mortgage until the full loan balance is repaid.

When does a wrap-around mortgage make sense?

For buyers, wrap-around mortgages offer these advantages compared to conventional mortgages:

• Easier to qualify: requirements are less strict than with banks.
• Lower down payments, higher leverage: buyers can purchase properties with less money down, often 10-25% down vs. 3-20% for traditional mortgages.
• No closing costs: the buyer avoids thousands in bank fees and closing costs.
• Creative financing: ideal for those who can't qualify for standard mortgages.

For sellers, the benefits include:

• Expediting a sale: by financing the buyer, deals can close faster
• Earning interest: acting as the lender lets the seller earn interest
• Long-term payments: 30-year wrap-around terms generate long-term income.
• Accessing equity: Sellers can access equity without a cash-out refinance.

When structured properly, wrap-around mortgages present big advantages for both parties. But they also come with sizable risks.

Risks of wrap-around mortgages

Wrap-around mortgages disadvantage buyers and sellers in several ways:

For buyers:

• Higher interest rates: usually 2-3% above market rates
• Complex terms: provisions vary and can be confusing
• Late payment penalties: stiff fees if payments are delayed
• Difficulty building equity: high rates hamper equity accumulation
• Refinancing difficulties: most banks don't refinance wrap-arounds

For sellers:

• Buyer default risk: the seller must cover payments if the buyer defaults
• Second lien risks: existing lender could call due the remaining balance
• Foreclosure risks: buyer default could lead existing lender to foreclose
• Tax headaches: additional paperwork and complex tax implications
• Balloon payment risks: if the seller’s existing mortgage has a balloon payment, the seller must cover it

Because of the risks involved, wrap-around mortgages work best when...

• The buyer has at least 10-20% to put down
• The buyer has good credit and income to handle payments
• The seller has plenty of equity and cash reserves
• The existing first mortgage has a fixed rate and no balloon

Who should (and shouldn't) use a wrap-around mortgage?

Wrap-around mortgages serve specific types of buyers and sellers.

Good fit for buyers who…

• don’t qualify for a conventional mortgage
• are buying a second home or investment property
• have a 10-25% down payment
• have good credit and income but limited mortgage options

Good fit sellers who …

• are retiring soon with paid-off homes
• are relocating and need to sell quickly
• want to avoid capital gains taxes on the sale of their property
• are seeking to access home equity without refinancing

Poor fit for buyers who…

• are first-time homebuyers with minimal savings
• have very low credit scores or income
• are seeking predictability and a clearly defined exit strategy

Poor fit for sellers who…

• are relying on property sale proceeds for retirement
• have minimal equity with an underwater mortgage
• are carrying a high mortgage balance on the property
• have an upcoming balloon payment on their mortgage

Assessing your financials and risk factors determines if a wrap-around mortgage aligns with your home buying or selling plans.

Alternatives to wrap-around mortgage financing

Before pursuing a wrap-around mortgage, buyers and sellers should consider these other options:

Buyers

• FHA loans if you have a credit score over 580 and 3.5% down payment
• VA loans for veterans and service members with no down payment
• USDA loans for rural and suburban properties with no down payment
• bank statement loans if you have proof of ability to pay but limited credit
• hard money loans based on the property rather than on your finances

Sellers

• home equity loan or HELOC to access equity without sale
• reverse mortgage to earn equity income while still owning the home
• cash-out refinance to tap into equity and keep existing mortgage
• traditional sale to qualified buyer with standard financing

Shopping multiple lenders and financing programs could reveal more attainable alternatives than tying yourself to a wrap-around mortgage.

What happens to a mortgage when a bank fails?

Wrap-around mortgages offer creative financing but also come with risks that both parties should carefully consider.

For sellers, a major concern is what happens if the buyer defaults and the original mortgage lender calls the loan due, resulting in headaches like having to cover missed payments or taxes.

Additionally, it's critical for both buyers and sellers to understand what happens if the bank with your mortgage collapses.

If the bank that holds your mortgage fails, your loan will be transferred to another bank. But the new bank may not want to service a unique wrap-around mortgage.

So what happens to a mortgage when a bank fails?

The viability of wrap-around financing could be threatened, leaving you scrambling for alternatives. You may have trouble finding another lender willing to take on an unconventional loan.

What could happen if your bank collapses can greatly impact your wrap-around mortgage, so it’s an important risk to weigh when considering this as a financing option.

The lowdown on wrap-around mortgages

Wrap-around mortgages enable creative home financing but also pose significant risks if not structured prudently. They strategically serve certain buyer and seller situations.

For buyers with limited options or sellers in a bind, wrap-around mortgages facilitate deals that otherwise may not be possible.

But before you assume this is your only path to homeownership, pursue all conventional financing routes first.

While the unique structure provides opportunities, the wrapped financing also brings potential pitfalls for both parties. As always, tread carefully and consult professionals to safeguard your financial interests.