While home buyers might hope that they will qualify for a mortgage from the usual financial institutions, like a bank, they may find that their spotty credit score is an obstacle that prevents them from qualifying. What then? One Plan B may be to get what’s known as a wraparound loan.
A wraparound loan is where a home buyer takes out a loan from the home sellers, who then “wrap” this new loan around the mortgage they already owe on a home. The sellers continue paying the original mortgage, while the buyers pay off their own wraparound loan to the sellers, which the sellers might use to help pay off their original loan, or else just pocket the money.
Wraparound loans offer certain benefits to buyers and sellers, although this arrangement comes with risks. When in doubt, crunch the numbers with an online mortgage calculator to see what you can easily afford. Here’s what to know about wraparound loans, to determine if this type of mortgage is right for you.
What is a wraparound loan?
Wraparound loans are a type of seller financing—where the seller loans the buyer money to purchase the house—but the key difference with a wraparound loan is that there are two lenders: the seller, and the lender for the original mortgage.
“With [traditional] seller financing, the seller is the only lender,” says Denny Ceizyk, a mortgage expert at LendingTree. “With a wraparound loan, there are effectively two loans.”
There’s the seller’s existing mortgage on the home, which remains intact, and the new, wraparound loan the buyer pays the seller, which covers whatever price the buyer has agreed to pay for the home.
Wraparound loans are considered a “junior mortgage.” A junior mortgage is an additional loan that exists alongside the primary loan—both of which are secured using the house as collateral.
How wraparound loans work
To start a wraparound loan, the buyer and seller agree on a price for the home. Then the seller gives the buyer a loan that covers the difference between the amount owed on the existing mortgage and the home’s new sales price.
For example, let’s say the balance due on the original mortgage is $100,000, and the buyer agrees to purchase the home for $250,000. The seller would create a second mortgage for the difference, which would be $150,000.
From there, “The buyer makes the payments to the seller on the new loan, while the [seller] who holds the second mortgage makes the payments on the original first mortgage,” says Lucy Randall, director of sales and service operations at the online mortgage company Better.com.
Benefits of a wraparound loan
Wraparound loans are unconventional, Randall says, “but it can be an opportunity for both home buyers struggling to obtain a mortgage and sellers in distress.”
Wraparound loans give buyers an alternative way to purchase property when they have a low credit score and don’t qualify for a traditional mortgage. Buyers may also be able to negotiate a better price for the home and a faster closing time frame, since they’re working directly with the seller.
So what’s in it for the seller? Sellers can (and in most cases should) negotiate a higher mortgage interest rate on the wraparound loan than the interest they pay themselves. This, in turn, would enable the sellers to earn a profit that could go toward paying off their own loan or other expenses.
“A wraparound loan works best for buyers who do not qualify for traditional mortgages with lenders and sellers who aren’t able to pay their mortgage on their own,” explains Brian Walsh, a certified financial planner with the online personal finance company SoFi.
Another benefit for sellers is that they can also complete the sale more quickly—an important consideration if their home has been sitting on the market for a while.
The risks of wraparound loans
Despite the benefits of a wraparound loan to both buyers and sellers, “both should be mindful of the risks on both sides before agreeing to this type of financing,” Walsh adds.
Both buyers and sellers take on extra risks with wraparound loans, since either party could default on the loan at any time, leaving the other side in the lurch.
For instance, if the buyers don’t make their mortgage payments, the sellers still have to make their own mortgage payments or risk defaulting on their loan.
“If the buyer can’t make those payments, the seller could then fall into default on their mortgage, meaning that their lender could take over ownership of the home through the foreclosure process,” Randall explains.
“The seller’s mortgage takes priority over the wraparound loan, which means if the seller doesn’t make the mortgage payments, the bank could foreclose,” agrees Ceizyk.
Sellers should check with their existing mortgage lender before getting into a wraparound loan, to make sure their loan doesn’t have a due-on-sale clause. This clause requires homeowners to pay off their mortgage in full when they sell their home, and prevent them from participating in a wraparound loan.
Likewise, buyers risk foreclosure in a wraparound loan if the sellers don’t keep up their end of the bargain to pay the original mortgage, Walsh says. And, sometimes, in addition to paying higher interest rates, buyers may be asked to shell out for a large, nonrefundable down payment.
“The buyer owns property subject to someone else’s mortgage—the seller’s. Which means if the seller defaults, the buyer could end up losing the home,” Ceizyk says.
Should you consider a wraparound loan?
Wraparound mortgages are rare, probably because they’re complicated. Most buyers and sellers find traditional lenders and conventional or government-insured mortgages, such as a U.S. Department of Veterans Affairs or Department of Agriculture loan, much easier to work with, Randall says.
But sometimes, a wraparound loan may be the only way a buyer can qualify for a loan, and for homeowners to sell their home. In that case, a wraparound loan can be a helpful step to accomplish both of these goals.
“Buyers who can’t qualify for a mortgage or don’t want the hassle with the paperwork may benefit from a wraparound loan,” Ceizyk says. “Sellers having trouble selling a property with an existing mortgage or looking to convert equity into cash flow may be a good fit for a wraparound mortgage.”
Just be sure to crunch your numbers in a mortgage calculator and research all of your options before committing to any type of mortgage, Walsh urges.