QWe have found a house that we would like to purchase. Our credit is strong, and our household income is good. However, it is not high enough to qualify for the loan necessary to purchase this house.
The sellers are willing to hold paper for the sale price, and each month we would pay them interest only. We have the option to make periodic principal payments to reduce our obligation. However, the sellers have an existing mortgage on the property. Is there any way we can structure an arrangement that would allow the current owners to retain that mortgage? The sellers believe that under such a procedure, they can make additional money from the monthly payments we will be giving to them.
AThe process you are considering is called a wraparound mortgage. Such an arrangement is legal, but you do run the risk that the current lender may call the loan because it may violate the "due on sale" clause that is contained in your sellers' loan documents.
Here's an example: You want to purchase the property for $300,000 and there is an existing mortgage in the amount of $200,000. That mortgage carries an interest rate of 5.5 percent, and the monthly mortgage payment is $1,135. The seller is prepared to sell the property to you and take back a loan in the full amount of $300,000. You will pay the seller interest only on that new loan at 6.5 percent. Your monthly payment will be $1,625.
In other words, the seller will remain obligated to pay $1,135 a month to the current lender each month, but will get $1,625 from you -- for a monthly gain of $490.
Sounds good? Here's how it will be structured. The seller will give you a deed to the property. You will sign a promissory note in the amount of $300,000 in favor of the seller, and agree to pay 6.5 percent a year in interest. To protect the seller -- and to assure that you can deduct your interest payments for income tax purposes -- you will also sign a deed of trust, which will be recorded in the jurisdiction where your property is located.
Keep in mind that this is a second deed of trust. The first deed of trust is in favor of the original lender, whose loan will not be paid off when the deed is recorded into your name. In effect, your second trust is wrapped around the existing first trust, and thus the name wraparound mortgage.
During periods when interest rates were very high, such as in the 1970s, many buyers and sellers used the wraparound mortgage so that buyers could take advantage of the lower mortgage interest rates in the sellers' existing mortgages.
However, there is a major catch: the "due on sale" clause, which almost all mortgages contain. It was specifically designed to protect lenders. If they made a loan of 5 percent to borrower A, and if rates are at 7 percent when B wants to buy A's house, B should not be able to assume that low interest rate.
The wraparound mortgage is legal, but there is always the risk that the lender will learn about the new transaction and call the original loan. Thus, while this procedure sounds like a win-win situation for you and your seller, it risks becoming a lose-lose.
I am not suggesting that you ignore this option, but you should consider it only as a last resort. Are you absolutely sure that you cannot get a new mortgage loan? Have you talked with other mortgage lenders, including the lender that holds the existing first trust on the property? Have you considered getting a smaller loan -- one that you can afford -- and having the seller take back a smaller second trust? That second trust can carry a higher mortgage interest rate, to compensate the seller for holding this paper.
If you decide to go the wraparound route, there are several things that should be included in a written document.
* Who will pay the first mortgage lender? No matter who makes the payment, the other party to the transaction must be provided proof of the payments periodically. You don't want a situation in which the sellers think you are paying the mortgage, and you think that the sellers are making the payments -- and nobody is really paying.
* Make sure that the wraparound mortgage is properly recorded in the land records.
* Confirm that there is adequate homeowner insurance that makes both lenders beneficiaries under the policy in the event that there is damage to the property.
* At the end of each year, you (as buyer-borrower) are entitled to take all of the mortgage interest deductions on your annual income tax return. You must make sure that you have an accurate -- and complete -- accounting. Keep in mind that the first-trust lender will continue to send notices and tax forms to your sellers.
* Your sellers are obligated to send you, each year, an IRS Form 1098, reflecting the mortgage interest that you have paid them.
A wraparound is a useful tool for buyers and sellers. However, your and your sellers should enter into this transaction with your eyes wide open and only after you both receive independent legal advice.
Benny L. Kass is a Washington lawyer. 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.