How a wraparound mortgage works, with a worked example

What a wraparound mortgage is

A wraparound mortgage, or wrap, is seller financing layered on top of a loan the seller still owes. The seller sells the house and carries a new note for the buyer. The seller's old loan stays in place. The new note wraps around it.

The buyer makes one payment to the seller. The seller uses part of it to pay the old lender and keeps the rest. That leftover amount is the seller's spread, and it is the main reason sellers offer wraps.

Wraps get attention when rates are high. A seller with a 3% loan from years ago can offer a buyer financing at a rate below what a bank charges today and still earn more than the old loan costs.

How the money moves each month

At closing, the buyer pays a down payment to the seller and signs a note for the rest of the price. That note is usually secured by a mortgage or deed of trust that sits behind the seller's existing loan.

Each month the buyer pays the wrap note. The seller, or better, a licensed servicer, pays the underlying loan out of that money. Whatever is left belongs to the seller.

Two balances shrink at different speeds: the wrap balance the buyer owes the seller, and the underlying balance the seller owes the lender. The gap between them is the seller's equity still carried in the note. When the wrap is paid off, by a balloon, a refinance, or a sale, the seller pays off the underlying loan from the proceeds and keeps the rest.

Example

Illustrative example. These are the same sample numbers loaded in the wraparound mortgage calculator, so you can follow along. A seller agrees to sell for $300,000 and still owes $150,000 on a 3% mortgage with 25 years left. The buyer puts $30,000 down. The seller carries a $270,000 wrap note at 7%, with payments on a 30-year schedule and the balance due in year 5.

Payments. The buyer pays $1,796.32 a month in principal and interest on the $270,000 wrap. The seller's existing loan costs $711.32 a month. The seller keeps $1,085.00 a month, the spread.

Interest in month one. The buyer pays $1,575 of interest (270,000 × 0.07 ÷ 12). The seller pays $375 of interest (150,000 × 0.03 ÷ 12). The interest spread that month is $1,200. The rest of each payment goes to principal on both loans.

Equity. The seller has $150,000 of equity at the sale ($300,000 − $150,000), before selling costs. The buyer's $30,000 down payment comes out of that equity right away. The other $120,000 stays in the note, earning the spread.

Balances by year. After year 1 the wrap balance is $267,257.31 and the underlying balance is $145,908.24. After year 2: $264,316.36 and $141,692.02. After year 3: $261,162.80 and $137,347.57. After year 4: $257,781.27 and $132,870.97. After year 5: $254,155.29 and $128,258.21.

The balloon. After the 60th payment the buyer owes a balloon of $254,155.29. The seller still owes $128,258.21 on the old loan. When the buyer refinances and pays the balloon, the seller pays off the old loan and nets $125,897.08.

Total seller cash. $30,000 down, plus $1,085.00 × 60 = $65,100 of spread, plus the $125,897.08 net at payoff, is about $220,997 over five years, before taxes and costs. That is about $70,997 more than the $150,000 of equity the seller had at the sale. As a nominal annual yield (monthly return × 12) on the $120,000 the seller left in the note, counting the monthly spread and the payoff, it works out to about 11.58%, well above the 7% wrap rate. It is measured against the seller's $120,000 equity in the note, not the $300,000 price, and it is before taxes and costs. Compounded monthly, that is about 12.2% a year.

Why the seller's yield beats the wrap rate

The buyer pays 7% on all $270,000. The seller only pays 3% on the $150,000 it still owes. So the seller earns 7% on its own $120,000 of equity, plus a 4-point spread on the lender's $150,000. That second piece is leverage. It is why the yield on the seller's equity in the example lands near 11.6% instead of 7%.

Leverage works both ways. If the wrap rate were below the underlying rate, or the buyer's payment were smaller than the underlying payment, the seller would be paying to carry the deal. The calculator flags a negative spread so you see it before you sign.

Pros and cons for the buyer

Pros: a buyer who cannot get a bank loan, or who wants a lower rate than banks offer today, may get in with a wrap. Closing can be faster and cheaper than a bank loan, and the terms are negotiable.

Cons: the buyer depends on the seller to keep paying the old loan. If the seller stops, or the lender calls the loan, the buyer can lose the house even with every payment made on time. A balloon means the buyer must refinance or sell by a set date. Title insurance, a recorded deed and mortgage, and a third-party servicer reduce these risks but do not remove them.

Pros and cons for the seller

Pros: the seller can reach more buyers, sell at a fuller price, earn a monthly spread, and earn a higher yield on equity than the wrap rate alone. Spreading the gain over several years may also change how it is taxed, which is a question for a CPA.

Cons: the seller stays on the hook for the old loan. If the buyer stops paying, the seller still owes the lender and may have to foreclose to get the house back. If the lender enforces its due-on-sale clause, the seller must pay off or refinance the old loan on the lender's timeline. And the seller's equity is tied up until the buyer pays the wrap off.

The due-on-sale clause

Most home loans include a due-on-sale clause: if the property is sold or transferred without the lender's consent, the lender may demand the full balance. Federal law, the Garn-St Germain Act at 12 U.S.C. 1701j-3, generally lets lenders enforce these clauses despite contrary state law.

That law also lists transfers a lender may not use to call a loan on homes with fewer than five units, such as a transfer to a spouse or into a living trust where the borrower stays a beneficiary. A sale to an unrelated buyer is not on that list. Some lenders never act on a wrap; some do. You cannot know which in advance, so plan for the lender calling the loan.

Licensing and owner-financing rules

Federal loan originator rules under Regulation Z, which came out of the Dodd-Frank Act, include two narrow exclusions for seller financers at 12 CFR 1026.36(a)(4) and (a)(5). The first covers a seller financing three or fewer properties in 12 months, but the note must be fully amortizing (so a balloon note does not fit), the seller must decide in good faith that the buyer can repay, and the rate must be fixed or adjustable only after five or more years. The second covers a natural person, estate, or trust financing only one property in 12 months. It does not require full amortization, so a balloon is allowed, but there can be no negative amortization and the rate must be fixed or adjustable only after five or more years. Both require that the seller owned the property and did not build the home as part of their business. A seller who does a second deal inside 12 months loses the one-property exclusion.

Those exclusions only answer one federal question. State licensing laws under the SAFE Act, ability-to-repay rules, disclosure rules, usury limits, and foreclosure law can still apply, and they vary by state. A real estate attorney in the property's state should draft the note, the security instrument, and any disclosures. These rules matter most when the buyer will live in the home. Owner-occupied sales are consumer credit, so ability-to-repay, disclosure, and licensing rules are most likely to apply.

Use a servicer and escrow

A licensed loan servicer or escrow company can collect the buyer's payment, pay the underlying lender first, send the spread to the seller, and keep records both sides can see. It also tracks property taxes and insurance, which this example leaves out. That protects the buyer from a seller who stops paying and protects the seller from disputes about what was paid.

Common pitfalls

Treating the spread as profit. Part of each payment is principal on both loans, and the seller still has to pay off the underlying balance at the end.

Ignoring the end date. If the underlying loan outlasts the wrap, or the buyer's balloon is smaller than what the seller still owes, the seller must bring cash to close it out.

Skipping the paperwork. A handshake wrap with no recorded documents, no title insurance, and no servicer puts both sides at risk.

Forgetting taxes and insurance. The payments in this guide are principal and interest only. Decide in writing who pays property taxes and insurance, and how.

Sources

12 U.S.C. 1701j-3, Preemption of due-on-sale prohibitions (Garn-St Germain Depository Institutions Act of 1982), via Cornell Law School's Legal Information Institute, law.cornell.edu.

12 CFR 1026.36(a)(4) and (a)(5), seller financer exclusions from the loan originator definition, ecfr.gov and law.cornell.edu.

Consumer Financial Protection Bureau, Loan Originator Rule Small Entity Compliance Guide, https://files.consumerfinance.gov/f/documents/cfpb_loan_originator_small_entity_compliance_guide.pdf. Explains when a seller financer is not a loan originator.

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