Exploring the pros and cons of wraparound mortgages

Buying a home can be challenging for some homebuyers, no matter what's happening with the economy. If you're having trouble with saving for a down payment – or experience credit issues and have difficulty proving income – traditional mortgages may not be a realistic option for you. 

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A wraparound mortgage might be a good option for homebuyers who cannot get approved through conventional financing and sellers whose homes have been on the market for too long. Learn more about wraparound mortgages, including how these loans work, the pros and cons for buyers and sellers, and alternative borrowing options to consider.

What is a wraparound mortgage?

A wraparound mortgage is a unique home loan that "wraps around" the seller's existing mortgage. While these home loans are not typical, they offer a unique financing option to help homeowners sell their homes and buyers get approved for a mortgage.

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With a wraparound mortgage, the buyer assumes the current mortgage plus an additional amount based on the home's value and the buyer's down payment. The home secures the new loan, but its lien is in second position behind the original mortgage in case of default. The buyer signs a promissory note and makes payments to the seller, who then makes their monthly mortgage payment and pockets the difference as profit.

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For example, a homeowner with a $175,000 mortgage balance is selling their home for $275,000. The buyer makes a $50,000 down payment and does a seller-financing mortgage for $225,000. The seller gets $50,000 immediately and continues making their existing mortgage payments. Each month, they'll profit from the difference between the original loan and the new purchase price.

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However, for these loans to work, the existing mortgage must be "assumable" and approved by the original lender. Otherwise, the "due on sale" clause that's included in most mortgages requires that the loan be paid immediately when the home's title transfers to another person. Wraparound loans are a form of seller financing. 

The pros and cons of a wraparound mortgage

Whether you’re buying or selling a home, there are many factors to consider before entering into a wraparound mortgage. 

Advantages of a wraparound mortgage

Benefits for buyers

• Easier to qualify – Sellers may be more willing to overlook negative marks on your credit that cause lower credit scores. The seller may offer more flexibility with the structure of the loan as well.
• Lower closing costs – You may be able to avoid many of the fees that a lender charges to originate a traditional mortgage. This can lead to lower closing costs than what is charged on a conventional mortgage.

Benefits for sellers

• Sell your home quickly – With a wraparound mortgage, sellers may be able to find a buyer more quickly. Since the buyer does not have to qualify for a traditional mortgage, they are able to more easily qualify to buy the home.
• Continuous income – Wraparound mortgages offer the seller an income stream they can rely on. Seller-financing provides monthly payments from the buyer, and the seller also profits from the spread between the interest rate it charges the buyer versus the rate of the original mortgage.
• Loan secured by the home – Sellers are protected by the value of the home in case the buyer defaults on the loan. Like a traditional mortgage, if payments to the seller are not made, they can foreclose on the home.

Disadvantages of a wraparound mortgage

Risks for buyers

• Higher interest rates – Although wraparound mortgages are easier to obtain, they often come with a higher interest rate. Higher rates lead to bigger monthly payments, which can put a strain on your finances.
• Seller may not pay the mortgage – Since buyers pay the seller, they have no control over whether the original mortgage is paid. If the seller does not pay the original mortgage, the home could be foreclosed on, even if the buyer has made every payment on time.
• Loan doesn't build credit – Since the wraparound mortgage is seller-financed, it likely will not be reported to the three major credit bureaus. Regular monthly payments on a term loan are a good way to build credit.

Risks for sellers

• Loan is not assumable – In order to offer a wraparound mortgage, the existing mortgage must be an assumable loan. Most conventional mortgage loans do not offer this feature, which shuts out many homeowners from pursuing this strategy. Government-backed loans, like VA loans, FHA loans, and USDA loans, may allow a buyer to assume the mortgage.
• Risk of buyer non-payment – When a buyer does not make their monthly payments, it can impact the seller’s ability to make payments to the original lender. If the seller buys a second home, they are responsible for two mortgage payments. A high debt-to-income ratio can impact the seller's ability to get the best rates and terms on other loans.

Alternatives to a wraparound mortgage

Using a wraparound mortgage can be an excellent option in certain situations. However, these loans are not common ways to buy or sell a home. Before pursuing this home loan strategy, consider these financing alternatives, which may be a better option.

• FHA loans – FHA loans are government-backed loans that have low closing costs and offer down payments as low as 3.50%. These loans offer interest rates that are competitive with conventional mortgages, but they typically target first-time homebuyers and borrowers with lower credit scores.
• USDA loans – The USDA loan program targets low-income borrowers who live in rural areas. These loans do not require a down payment, and they provide lower monthly payments with loan terms of up to 38 years for those with very low income.
• VA loans – Active-duty, military veterans, and their surviving spouses can take advantage of exclusive home loan programs by the Veterans Administration. These loans allow borrowers to purchase a home with competitive interest rates, no down payment, limited closing costs, and private mortgage insurance requirements.
• Rent-to-own agreements – In a rent-to-own agreement, a tenant pays a monthly rent higher than market rates with the intention of exercising a purchase option at a later date. The landlord sets aside a portion of the monthly rent for a future down payment when the tenant can qualify for a loan.
• Home equity – If you're considering selling your home to buy a second home, accessing your home equity may be a better option. A home equity loan or HELOC can be a good option if you are able to make the payments and get qualified. A home equity investment is best when you don't want another monthly payment or if you don't have perfect credit. 

Frequently asked questions

How does a wraparound mortgage differ from a traditional mortgage?

The biggest difference between a wraparound mortgage and a traditional mortgage is that the homebuyer makes payments to the seller instead of a bank. As payments are made to the seller, the seller pays the existing mortgage payment and pockets the difference as profit on the sale of their home.

How long does it take to close a transaction involving a wraparound mortgage?

One of the primary benefits of a wraparound mortgage is that the transaction can close quickly. These home loans can close in as little as a few days, depending on how long it takes for the existing lender to approve the buyer. The closing process is streamlined by using the current homeowner's existing appraisal and title work.

Who holds the title in a wraparound mortgage?

There isn't a definitive rule on who should hold the title with a wraparound mortgage. Depending on how the loan terms are negotiated, the home's title may remain with the seller or be transferred to the buyer immediately. If the seller retains the title, it will transfer to the buyer when the loan is paid off.

What happens if the seller defaults on the primary mortgage in a wraparound arrangement?

If the seller defaults on the original mortgage, the home could be foreclosed upon. This is a major risk of wraparound mortgages because the buyer does not control whether the original mortgage lender is paid. To avoid this scenario, the buyer should require access to the mortgage account to verify payments are made and have a clause that allows them to pay the lender directly in case of a buyer's non-payment. 

Final thoughts

To buy a home, sometimes you need to be creative. A wraparound mortgage enables borrowers to buy a home without needing to qualify for a conventional mortgage. They enter into an agreement with a seller where the buyer makes monthly payments to the seller while the seller continues making payments to the original lender. While there are risks to be aware of, this home loan option can make the dream of homeownership a reality for borrowers with poor credit or hard-to-prove income.

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