Wraparound Mortgage: What Is It And How It Works
If you’re having trouble qualifying for a traditional mortgage, there may be another financing option available. A wraparound mortgage is a form of seller financing that’s designed to benefit both parties in the purchase.
Buyers may have a better chance at qualifying for a home loan, and sellers can profit. However, both the buyer and seller should understand the benefits and drawbacks of this financial arrangement.
What Is a Wraparound Mortgage?
In a traditional home purchase, the buyer borrows money from a lender and uses it to pay the seller for the home. A wraparound mortgage is different in that the seller keeps their original loan and extends financing to the buyer. The seller’s loan is the wraparound mortgage—it’s being wrapped around the original home loan.
The buyer sends their monthly payment to the seller, who uses some of the money to make the mortgage payment. Because the seller can charge a higher interest rate than the one they’re paying, they’ll earn a profit in the process. In exchange, the buyer gets financing when no cheaper options are available.
Wraparound Mortgage Example
Let’s say that John bought a home several years ago for $300,000 and it’s now worth $350,000. With a fixed interest rate of 5%, John’s principal and interest payments total $1,288 each month. John wants to sell the home, and he gets lender approval to do a wraparound mortgage. A buyer named Jane agrees to pay $350,000 for the property with a $70,000 down payment and a 7% interest rate.
Jane sends John $1,862 each month per their written agreement, and John uses some of that money to pay off the original mortgage. Jane’s interest rate is higher than John’s, so he makes some profit—$574—each month.
A wraparound mortgage could also work if Jane only took out a loan for John’s remaining mortgage balance. He can still profit off the deal with the higher interest rate.
How Does a Wraparound Mortgage Work?
If a seller wants to offer a wraparound mortgage, they’ll need to check whether their home loan is “assumable.” An assumable mortgage is a home loan where the buyer takes over, or assumes, the same terms of the seller’s existing mortgage. Federal Housing Administration (FHA) loans, U.S. Department of Agriculture (USDA) loans and Veterans Affairs (VA) loans are assumable, but conventional mortgages typically are not.
If the seller has an assumable mortgage, here’s how the rest of the process works:
- The seller needs to get permission from their lender before moving forward with a wraparound mortgage.
- Once the buyer and seller agree to a wraparound arrangement, they’ll negotiate the loan amount, interest rate and down payment.
- Both parties will sign a promissory note that includes the terms of the mortgage.
- The seller keeps the existing mortgage on the home and either transfers the title to the buyer right away or once the loan is repaid.
- The buyer sends the seller their monthly payment, and the seller then pays the original lender.
Tip: A wraparound mortgage takes the position of a second mortgage or “junior lien.” If payments aren’t made—whether it’s the fault of the seller or buyer—the lender can recoup its losses by foreclosing on the property and selling it.
Pros of a Wraparound Mortgage
Wraparound mortgages can benefit both the buyer and seller in a few ways.
For the Buyer
- Easier qualification: Getting a standard mortgage can be difficult if you have a low credit score, a nontraditional job or a high debt-to-income (DTI) ratio. But it may be easier to qualify for a wraparound mortgage or receive better terms.
- Lower loan balance: Depending on what the seller agrees to, you might be able to borrow less with a wraparound mortgage—enough to cover the remaining loan balance and a small profit for the seller—compared to a standard mortgage.
For the Seller
- Potential for profit: Sellers can charge a higher interest rate than the one they have, which earns them a monthly profit.
- Widens the buyer pool: Offering a wraparound mortgage as a financing option can make the sale more accessible to some buyers since it’s more flexible and easier to qualify for.
Cons of a Wraparound Mortgage
There are drawbacks involved with wraparound mortgages for both parties, however.
For the Buyer
- Higher interest rate: Wraparound mortgages are a form of seller financing, which is typically more expensive than a traditional mortgage. The seller may charge a higher interest rate to cover their risk and earn a profit.
- Breach of contract: Another potential risk to buyers is if the seller agrees to a wraparound mortgage without getting consent from the original lender. If the seller breaches their original contract, the lender may be able to demand repayment in full or foreclose on the property.
- Seller could default: The buyer makes monthly payments directly to the seller, who in turn pays the mortgage. If the seller fails to make those payments, the lender may foreclose and force the buyer off the property. To reduce this risk, some buyers add a clause to their purchase agreement that allows for a portion of their payments to be made directly to the lender.
For the Seller
- Buyer could default: On the other side of the transaction, the seller also faces risk if the buyer fails to make their payments. The seller will need to either come up with the money out of pocket or miss payments, which can hurt their credit score.
Wraparound Mortgage Alternatives
Buyers typically seek wraparound mortgages when they’re having trouble qualifying for a standard home loan or getting affordable loan terms. But because of the risks involved, you might want to consider other options first.
- Improve your financial standing. Consider holding off on a home purchase for a few months. You may eventually qualify for a traditional mortgage if you can improve your credit score, pay off debt to lower your DTI ratio or save for a larger down payment.
- Check out government-sponsored mortgages. FHA loans, USDA loans and VA loans are all designed to make homeownership more affordable. Buyers who qualify may be able to get a home loan despite having a low credit score, a high DTI ratio or a low down payment. These loans also typically come with competitive interest rates, though buyers may be required to pay mortgage insurance.
- Seek down payment assistance. If you’re having trouble saving for a down payment, then you might find help through down payment assistance programs. These provide homebuyers with money to cover their down payment or closing costs. The money may come as a grant that doesn’t have to be repaid or a loan with affordable terms.
If you’re a seller looking for an alternative or a way to get out of your mortgage, ask your lender about relief options. You could also consider using the home as an investment property and renting it out.