Q: My wife and I are in the process of selling our home which we purchased about ten years ago. We have an existing assumable mortgage which carries a very low interest rate. Recently, a broker friend told us about a "wrap-around" mortgage. Can you tell us how this works and whether it would have any advantages or disadvantages for us?
A: There are problems with this kind of mortgage. Wrap-around mortgages gained popularity during the period of high interest rates in 1974 and 1975. A wrap-around mortgage works like this: You have an existing mortgage withh a present balanceeee of $25,000, and you are selling your home for $100,000. Your purchaser will require 80 percent financing, or a total loan ofof $80,000. One way to achieve this financing is for the purchaser to apply for a conventional 80 percent loan. Alternatively, the purchaser could assume your existing first trust (mortgage) and seek second trust financing for the remaining $55,000. Of course, the interest rate on the second trust will be higher than the interest rate on a new first trust.However, the combined effective interest rate (and the combined monthly payments) may be no greater than a single first trust.
A third way of working with this siituation would be a wrap-around trust. Under such an arrangement the purchaser would first assume your existing mortgage. You would then give to the purchaser what amounts to a second trust on the property for the full amount of the financing ($80,000) at a higher interest rate. You would also agree to make all payments of principle and interest on the first trust which the purchaser assumes. The purchaser winds up with monthly payments which are equivalent in amount as if a new first trust been placed.
You will receive payments at the stated interest rate based on a loan of $80,000, although at the beginning of the loan you are really only advancing $55,000. (Keep in mind the fact that you are agreeing to make the remaining payments of principle and interest on the first trust.) In addition to the fact that you have not advanced all the $80,000 at the inception of the loan, you will make a "profit" on the difference between the interest rate of the first and the interest rate on the second trust. The result to you is a yield (profit) in excess of the amount of interest stated in the second trust.
This situation may seem to be too good to be true but there are problems too:
1. There is a question of usury. Local jurisdictions have statutory interest ceilings which must be observed. Since the wrap-around may well result in an actual interest rate exceeding the statutory maximum, great care must be taken in drafting the loan documments to assure that you stay within the legal limit. As a result of this problem, wrap-around mortgages are used predominantly in commercial or corporate transactions, and are rare in the private sale of real property. Nonetheless, a wrap-around mortgage can be structured so it does not violate the usury laws.
2. Another question that sometimes arises is that of intervening liens. Suppose, for example, the purchaser places a third mortgage on the property. Will this third obtain priority over subsquent advances made by you in payment of the first mortgage. Because of this uncertainly, it is normal for the purchaser and seller to enter into a separate subrogation agreement which provides, in effect, that you will obtain a lien priority equal to that of the first trust with respect to all payments made by you on that trust. This is known as the "doctrine of conventional subrogation."
3. The buyer may object to this format since it inhibits his ability to place further financing on the property. Rather than being encumbered by a single loan in the amount of $80,000, the property will be subject to total liens of the first and second mortgages in the amount of $105,000.
4. Since the purpose if for you to receive a benefit from the use of the wrap-around format, it is normal to provide that the purchaser cannot prepay the first mortgage. In a residential sale situation, however, this will inhibit the purchaser's ability to sell the property.
5. The purchaser may be somewhat hesitant to rely upon you to make payments on his behalf. You should note that you are not re-assuming the first loan. It remains the obligation of the purchaser.
Under the proper circumstances, a wrap-around mortgage can be both practical and advantageous. However, its utility is reduced in non-commercial transactions. Barring special circumstances, there are probably better ways to structure the transaction. I would suggest, for example, that you consider taking back a second trust for the remaining $55,000 at an interest rare which is above the present market, but which, when averaged with the lower interest on the first trust, will not increase the cost to the purchaser.