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.
----------------------------------------------------
Jack Sternberg is a nationally recognized expert on real
estate investment who's been in the business for more than
30 years. Sternberg's deals have totaled over $750 million
and he's been to the closing table more than 1,500 times.
For more, visit http://www.askjacksternberg.com
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