What Are We Wrapping Around, Exactly? A Brief Overview of Wraparound Financing Transactions.
So, what is a wraparound transaction anyway? In short, a Wraparound or Wrap Transaction, is when a homeowner sells a home via Owner Financing and leaves the original (or underlying) loan in place. Just like any other owner finance, the Buyer gets title via some sort of Warranty Deed, and Buyer signs a Promissory Note and Deed of Trust. When creating a Wraparound Transaction, the new note (“Wraparound Note”) is generally the same amount or in excess of the balance or payoff of the underlying note (“Wrapped Note”). (The Wraparound Note should never be less than the Wrapped Note—when it comes time to pay off the Wrap Note, you don’t want to have to take money out of your pocket to pay the underlying lien because the payoff of the Wrap wasn’t enough to cover the underlying Wrapped Note.) The Wraparound Note/Deed of Trust become junior liens to the existing Wrapped Note. When this new Buyer pays their Note, that payment is used to directly pay the Wrapped Note. Keep in mind, the Buyer is not “assuming” the underlying note.
Here’s an example of a “Wraparound” transaction:
Sally Seller owns a home at 123 Anystreet in a new development with an appraised value of $150,000.00 which she purchased 7 months ago with a loan for $125,000.00. Unfortunately, Sally has to move to a new city and needs to sell her home. Sally’s neighborhood is still building new properties, so it’s been hard for her to find a new buyer at the price she wants so she doesn’t lose money at closing. A good option for Sally would be to sell her home via owner financing. She can sell the property for a total of $160,000.00, request a down payment of $25,000.00 and finance the remaining amount of $135,000.00 at a higher interest rate. Note only will Sally capture her equity in the property, she will have created monthly passive income with the new payments (the difference between the wrap payment and her underlying note).
Another option, if Sally wasn’t interested in doing her own Owner Finance, would be to sell her property Subject To the mortgage to Irma Investor. Irma Investor can take over the property and the mortgage(again, not an assumption—just taking over payment—see Subject To post if you’re not familiar with these), and then sell the property via owner financing using the above format. Sally may be able to get some money in her pocket from Irma Investor and can move on without having to keep track of an owner finance. Irma Investor can capitalize on that down payment and repay herself for any out of pocket costs, as well as retain that passive income produced by the difference between the Wrap and Wrapped payments.
What about the “Due on Sale” clause?
One of the biggest worries regarding Wraparound Transactions is the “Due on Sale” clause contained in the underlying mortgage. Most, if not all, mortgages will contain a Due on Sale clause. This clause essentially states that the loan is not assumable, and if any portion of interest in the property is sold or transferred without paying off the mortgage, the Lender may accelerate the loan and request payment of the note in full.
Because of this clause, a lot of people think that Wraparounds are “illegal” or even a “breach of contract” with the underlying lender. Luckily, Wraparounds are neither of those…in fact, they are perfectly legal and the lender can’t sue you for breach of contract if you do sell a property without paying off the mortgage. The clause generally states that the lender “may” call the note due. That means they don’t have to call the note, and it also implies that while it’s frowned upon, it’s not prohibited. So fear not—while these transactions are a bit more risky because of this clause, they aren’t illegal.
With such risk, you may be wondering, “Why would someone buy a property using Wraparound Financing when they can just look for a regular loan?” There is no simple answer to this, but one of the main reasons is that the potential Buyer cannot get traditional financing. Maybe they don’t have the best credit for one reasons or another, or maybe they have enough income, but it doesn’t always come in consistently—whatever the reason is, there’s always buyers out there for these types of transactions.
Pre-closing Considerations
Wraparound transactions can be fairly tricky, but once you get the hang of them, you’ll be able to do them with ease with the help of your closing attorney (hopefully that’s me). Here are some points and issues that you want to take not of as you get your transaction put together:
When you create a Wraparound contract, be sure to include a disclosure in the contract noting that it is a wraparound. For example, in the special provisions, I would include a clause that states “This is a wraparound financing transaction where the underlying loan will not be paid off at closing and the underlying lien includes a due on sale clause”
Not only should you include a disclosure in your contract, you should sit down and explain the transaction to your buyer. If you fail to fully explain the transaction, you risk your buyer backing back due to lack of understanding.
If you’re in Texas, be sure to include the Texas Property Code Sec. 5.016 disclosure (I have a sample under my Forms tab on my website)—and know what it means..
o This is a required notice anytime a property is sold with a loan in place
Advise the buyer of how to setup their insurance. Since there is an underlying lender, you’ll want to be sure they’re listed as First Mortgagee. You also want to ensure that the prior Mortgagor is listed as an insured or additional insured as well
o Please note that there are quite a few ways to set up insurance on a Wraparound and there is no perfect way to do so.
Use a Note Servicer and if possible, require in your contract that Buyer setup and maintain an automatic draft for payments. Not only will a Note Servicer give your Buyer some reassurance, the note servicer will help you with complying with lending laws in terms of sending statements as well as sending out tax forms at the end of the year.
Qualify your buyer! Not only will this ensure your buyer can pay and you’ll be less likely to need to foreclose on your buyer in the future, it will help you be in compliance with lending laws.
o One of the best ways to qualify your Buyer is to use an RMLO (Registered Mortgage Loan Originator)
Compliance Considerations
Any time you do an owner finance, whether a Wraparound or Traditional Owner Finance, you are considered a Lender. That being said, there are quite a few rules and regulations that you’ll need to comply with. The biggest are the SAFE Act (Secure and Fair Enforcement of Mortgage Licensing Act) and Dodd-Frank (Federal Mortgage and Anti-Predatory Lending Act). Both of these sets of legislation affect you as an owner finance lender and you should be familiar with these laws if you plan to do any owner financing.
The SAFE Act provides that if you engage in owner finance transactions where the property is not the seller’s homestead nor is it sold to a family member, you must be a licensed loan originator. Of course, there are some exceptions to this rule, one being it does not apply if you do fewer than 5 owner financed loan in a year.
The Dodd-Frank Act overlaps the SAFE Act in many ways as it governs residential loans and lending practices. The main focus of Dodd-Frank is to ensure that lenders qualify their buyers and determine that the buyer has the ability to actually repay their loan. Dodd-Frank was enacted after the extensive issues in the US when lenders were giving out loans to sub-prime borrowers who couldn’t repay their loans. Among other things, Dodd-Frank has a de minimis exception stating that there are exceptions for individuals not doing more than three owner finances per years. The loans must be at a fixed rate and fully amortized over 30 years--there can be no balloon (note there are exceptions to this).
The main reason for touching on these two Acts is to say that if you’re doing any sort of Owner Financing, you should always you an RMLO to originate your loan. Not only does it protect you, it ensures the buyer can pay the loan and gives all parties some relief.
Please note that this is only a brief (very brief) synopsis of these laws and you should take the time to review them and determine what you need to do to be in compliance.
Conclusion
If you’re thinking about doing a Wraparound Transaction—do it! I am more than happy to help guide you through the process. I can help you determine what contracts you need, how to fill them out and close out your transactions.
Disclaimer: the information provided in this article is for general educational purposes only and is not to be considered legal advice that anyone may rely on. Every situation is different and if you have a legal issue you should consult an attorney or related professional regarding the specifics of your individual circumstance. This firm does not represent you or anyone else unless it is expressly retained in writing to do so.