Understanding a Wrap Around Mortgage
Historically a “wrap around mortgage” was used to accomplish a lower blended rate on real estate purchases in high interest rate environments.
For example, let’s presume a seller has an existing loan at 3% interest for 50% of the current value of a property priced at $800,000. The buyer has a 5% down payment but cannot qualify for a new 7% loan for 95% of the purchase price.
The seller secures a second note and deed of trust from the buyer for 45% of the purchase price and “wraps” that second around the first deed of trust which is not paid off nor released at closing. The blended or effective rate for all borrowed funds required to purchase is below 5% and the monthly debt service is $1,000 less than what it would be if the buyer obtained a new 95% loan at 7% interest. The property closes and the buyer takes title.
The Problem With Wrap Around Mortgages
The term “wrap” is the key to understanding this strategy. The seller does not pay off the first deed of trust and the buyer makes payments to the seller for both the original first loan and seller second. The seller then makes the payment on the first loan and pockets the portion of the buyers’ payment for the seller second. All well and good but for two problem areas; if the seller does not continue making payments on the first loan (called equity skimming) the buyer might lose the property to foreclosure. Second, the first lender could demand the first loan balance immediately payable under the Due on Sale (alienation) Clause in the deed of trust which requires full payment if the original borrower transfers the property.
Accomplishing a wraparound transaction without lender approval is much like allowing a subject to assumption in that the lender has not (and would not) approved the transaction, the seller does not obtain a release of liability, the due on sale clause remains in effect, and the buyer does not complete the credit approval process through the lender. All these activities likely constitute loan fraud.