Q. My wife and I have been trying to sell our house for some time. We purchased the house about 15 years ago, and we have an existing assumable mortgage that carries a very low interest rate. Recently, a 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. Wrap-around mortgages gained popularity during the period of high interest rates in the mid-1970s and then again in the early 1980s.
A. Wrap-around mortgage works like this. Suppose you have a mortgage with a balance of $80,000 at 8 percent interest, and you would like to sell your house for $150,000. Your purchaser is able to come up with 20 percent of the purchase price, or $30,000, and would have to obtain a $120,000 loan to buy your house.
One way to get this financing is for the purchaser to apply for a conventional 80 percent loan. Under this arrangement, the purchaser would have to pay appraisal and credit report charges, as well as points, which could be as high as $3,600 (3 points).
Alternatively, the purchaser could assume your first trust (mortgage) and seek second-trust financing for all or a portion of the remaining money, which in this case would be $70,000. 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 payment) may not be greater than a single first trust in the higher amount.
A third way of handling this situation would be a wrap-around trust. Under such an arrangement, the purchaser would first assume your mortgage. You would then give to the purchaser what amounts to a second trust on the property for the full amount of the financing ($120,000), although at the beginning of the loan you are really only lending $40,000.
Keep in mind that you are agreeing to make the remaining payments of principal and interest on your existing first trust. In addition to the fact that you have not advanced all of the $120,000 at the inception of the loan, you may make a "profit" on the difference between the interest rate of the first trust 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.
To be more specific, if you take back a second trust in the amount of $120,000 at, for example, 10 percent, and you continue to make the interest payments at 8 percent on the existing $80,000 first, you will be making 2 percent on the existing $80,000, and a full 10 percent on the $40,000 difference that you are lending to your borrower.
This situation may seem too good to be true, but there are problems also.
Although usury laws have been relaxed in recent years, once in a while you run into a situation where local law requires that certain conditions be met or imposes certain limitations on a second trust. You should discuss this with your attorney to make sure that you are not violating any local law.
Your buyer may also object to this format because it may inhibit his ability to place further financing on the property. Rather than being encumbered by a single loan, the property will be subject to liens of the first and second mortgages in the amount of $120,000. This may inhibit the buyer's ability to obtain a home equity loan, since the lender would no doubt be in third-trust position, unless you are paid in full on your wrap-around.
The purchaser may be somewhat hesitant to rely on you to make payments on his or her behalf. You can often solve this problem, however, by agreeing to send monthly or quarterly proof of payments to your borrower by sending him a copy of your monthly canceled checks. In some instances, the seller can give the borrower a year's worth of post-dated checks, and the borrower then sends the monthly payment check to the first trust lender each month on time.
Under the proper circumstances, a wrap-around mortgage can be both practical and advantageous. It can be a marketing tool when real estate is difficult to sell, since it assures the buyer that a loan is available, and clearly saves the buyer a lot of upfront lender costs.
You must make sure, however, that your loan is freely assumable. Additionally, since there is always the possibility that your borrower may default, you should make sure that the wrap-around deed of trust and promissory note that your buyer signs are valid and enforceable in your jurisdiction. It is advisable to have an attorney prepare the legal documentation in this case.
Benny L. Kass is a Washington attorney. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.