|What is a wraparound seller-financed note? It is simply a second promissory note carried back by a seller who continues to pay the existing first note. The key to a wraparound is that the seller continues paying the first note after selling the property, just as they did before they sold it. At the same time, they now receive a larger amount from their second note which is now owed to them by their buyer. The buyer gets title to the property, but the seller remains in control and remains legally responsible for payment of the first note. The first note, which is now "wrapped around" by the second note, is known as the "underlying" note. Thus, when you hear people say they just sold property on a wraparound and are still paying their underlying, it is not a secret code. It is common real estate jargon for a fairly common transaction. A wraparound is also sometimes called an "all-inclusive".|
For example, let's say you own property and are paying the underlying mortgage, which has a balance of $30,000.00. You want to sell the property. You would like to sell it for $90,000.00, yet keep control of the $30,000.00 underlying note to make sure that it gets paid. Your best option would be to sell the property for $90,000.00 to a buyer who has an adequate down payment, say $20,000.00, and who qualifies for a wraparound second mortgage note for the $70,000.00 balance.
In this case, the $70,000.00 second "wraps around" your existing $30,000.00 underlying first mortgage. The wraparound does not change the underlying mortgage at all. The $70,000.00 second wraparound is owed to you by your buyer, while you still owe $30,000.00 to your lender on your underlying mortgage. However, you now have a $40,000.00 equity as follows: Your sales price of $90,000.00, minus the $20,000.00 down payment, equals the $70,000.00 second mortgage wraparound note, minus the $30,000.00 first mortgage, equals a $40,000.00 equity in the second mortgage, your wraparound note. Why would you want to use wraparound financing? Because this simple transaction can solve some very complex problems:
One notable appeal of a wraparound is convenience. It has the selling point that your buyer has only one mortgage payment to make, whereas in an assumption or similar type of financing, your buyer will usually end up with two mortgage payments and a lot of red tape. Making the sole agreement with you, and paying on one wraparound note, is easier for your buyer to understand and may help you make the sale.
Better Than an Assumption
You will also find the wraparound to be a nearly ideal solution to the problems of selling on "assumption". There are two kinds of assumptions, one of which leaves you completely liable for paying the first mortgage, but completely unable to control the property or your buyer's performance. In a such a "simple" assumption, if the buyer fails to make payments on your first mortgage, you in many cases will not even know about it until the mortgage is about to go into foreclosure, and by then you may have no power to re-possess the property. Any of the buyer's late payments may automatically appear on your credit rating and public and legal documents. These are serious disadvantages of simple assumptions that sellers rarely take into consideration.
The other type of assumption is called a "novation", which is a legal term for a new agreement that substitutes one debtor for another and requires permission from the underlying first mortgage lender. Novation assumptions are expensive, time-consuming, and sometimes impossible to get. Even though a novation assumption removes your legal liability for the first mortgage, the underlying lender may charge substantial fees because your new buyer must undergo credit and financial investigation similar to what you did when you got the loan. Some lenders simply refuse to grant novation assumptions for policy reasons.
Assumptions are so precarious that sellers, when possible, should avoid using them altogether and use the wraparound instead. However, it is recommended that you get written permission from the underlying lender approving your sale of the property on a wraparound. If the underlying will allow an assumption, chances are the underlying will allow a wraparound sale. Even if your underlying includes a "due on sale" clause, calling for a payoff of the underlying if you sell the property, sometimes a lender will waive it and allow your wraparound sale to go through.
Using a Wraparound, Instead of an Assumption, Gives You These Advantages:
1.) Staying Informed. You completely avoid the problem of having your buyer fall behind on their wraparound payments without your knowledge. Because you make the payments on the underlying first mortgage yourself, you stay informed on the payment status of the underlying.
2.) Maintaining Control. Because the payments you receive from your buyer on the wraparound note are larger than the underlying, you have sufficient funds to pay the underlying first mortgage and are in control over the funds. If wraparound payments fall behind, you know it immediately. If necessary, you can foreclose on the property and thereby exercise the greatest control possible.
3.) More Money. Tailor the wraparound to get better terms and conditions from your buyer than those you are paying to your underlying first mortgage lender. For example, you can charge a higher interest on the wraparound than you are paying on the underlying, or you can get a larger monthly wraparound payment, or you can do both. Even a 1% increase in the interest rate would provide you with a nice additional amount every month over what you would get otherwise, because you would be making an additional 1% on the underlying principal balance. A higher monthly wraparound payment could mean a faster cash return to you.
4.) Income Tax Advantage. A wraparound is an installment sale and the payments you receive may be taxed as you receive them. The taxes you may owe on your profit can be spread out over the years the payments are received.
Structuring Your Wraparound
The first step in constructing a wraparound is to review the underlying first note and mortgage thoroughly because, in order to benefit financially, you must structure your wraparound with better terms than those in your underlying first mortgage. If you don't know the details of the underlying first mortgage, you can't make the wraparound better. It is not unusual to have more than one underlying, and you need to review all underlyings that you are planning to "wrap around".
The Basic Rule
The basic rule of wraparounds is this: Create equal or better terms on your wraparound than exist on the underlying. You want the principal balance, monthly payments, and the interest rate on the wraparound to be as large or larger than the underlying. If the underlying contains a balloon payment, for example, you must write a similar balloon payment into your wraparound. (With balloon payments, it's preferable to make the wraparound balloon payment due a few months earlier than the underlying, to give yourself time to pay the underlying balloon from other sources if you do not receive the balloon payment on the wraparound.)
Similarly, if the underlying contains a provision for collecting tax and insurance reserves, your wraparound must also include such a provision. If the underlying contains a pre-payment penalty, a variable payment clause, a variable interest rate, a late charge provision, a due on sale clause, or any other cost item, you must also write such items into the wraparound. Likewise, the general terms of the underlying, including promises to keep the property in good condition, to allow no waste, and so forth, must also be reflected in the wraparound.
Prepare Amortization Schedules
The second step in constructing a wraparound is to print out amortization schedules for both the wraparound and the underlying, to make sure that the wraparound takes at least as long to pay off as the underlying. It is important to understand the reasons for making them both amortize out at the same time. First, because you rely on the income from the wraparound to pay the underlying, you must construct your transaction so that the money flow from the wraparound does not stop before you pay off the underlying. This is a safeguard for both you and your buyer. It protects you from inadvertently spending the wraparound income on something else and it protects the buyer from your potential failure to pay on the underlying. This protection is vital for a successful wraparound. (Comment: If the underlying has a variable interest rate, you cannot print out an accurate amortization schedule).
Your amortization schedules on both the underlying and the wraparound will reveal if there is any difference in pay off dates.
If they pay off at different times, there are two basic ways to make them pay off simultaneously:
1.) If the underlying pays off first, you can hasten the wraparound payoff date by inserting a "payment in full" provision in the wraparound. This provides for a complete wraparound payoff at, or prior, to the underlying's payoff date.
2.) If the wraparound pays off first, you can hasten the underlying payoff date by arranging to make larger payments on the underlying so it pays off at the same time as the wraparound. Another approach to the problem of the wraparound paying off first is to lower the payments on the wraparound. Structure your transaction so that the wraparound payments become lower at the time the balances on the underlying and the wraparound are equal. From that point on, lower payments will extend the payoff date of the wraparound so it will pay off at the same time as the underlying. You want to make the wraparound pay off as rapidly as possible, which is why you should not allow lower payments for the entire term of the wraparound. Keep in mind that the faster the wraparound pays off, the more it's worth if you need to sell it for cash.
The ideal wraparound that pays off at the same time as the underlying is not the only approach. There may be reasons for allowing the underlying to pay off first. If you are not concerned about having to sell the wraparound for cash in an emergency, then lower payments, that continue longer than the underlying, may be your best option. The benefit of this choice is that once the underlying is paid off, and you no longer need to make payments on it, all of the wraparound payments go in your pocket. An increased cash flow, which extends far out into the future, may be exactly what you want. However, once you make this choice of lower wraparound payments over a longer period of time, you cannot undo it. If an emergency forces you to sell the wraparound, you will get less cash than if you had made it pay off sooner because of the time value of money.
An important aspect of income management is to make the monthly wraparound payment due sooner than the monthly underlying payment date. This way you will have the funds needed to pay the underlying on time to avoid late charges and a blot on your credit report. If possible, the best plan is to make one payment ahead on the underlying at the time your property sale closes. By doing so, you always have a month's leeway.
Fire and Hazard Insurance
Another cost management detail you must handle is to cancel your fire/hazard insurance on the property. Your buyer must obtain such insurance and if you fail to cancel yours, there will be two outstanding policies covering the property which is a waste of your money. You and the underlying should both be named on your buyer's policy, you as second mortgagee and the underlying as first mortgagee.
It is good practice to have a professional servicing agent collect the payments from your buyer and disburse the underlying payment portion to the underlying mortgage holder and the remainder of the wraparound payment to you. Using a professional servicing agent is preferable to allowing your buyer to pay the underlying portion directly to the underlying mortgage holder. The buyer legitimately wants an assurance that you will not fail to make monthly payments on the underlying, but if you allow such language into the wraparound note itself, it could render the note "non-negotiable" and thereby substantially decrease its cash resale value.
The reason your wraparound note may be non-negotiable with such language is that terms and conditions of another note would be governing the wraparound note. This negates negotiability and is language you wish to avoid. You can give your buyer assurance that the underlying will be paid by engaging a professional servicing agent to perform all collections and disbursements on time.
Limiting Your Responsibility to Pay the Underlying
Consider having a separate agreement with the buyer agreeing that you are not bound to pay the underlying payments unless you receive the payments from the buyer on the wraparound. In an extreme case, if your buyer quits paying you on the wraparound and the value of the property substantially diminishes you could "walk away" from the situation and take your losses without being concerned that the buyer could hold you responsible for keeping the underlying payments current. While this will not change your obligations between yourself and the underlying, it could help protect you from claims by your buyer.
Consult Your Professionals
Be sure to consult a qualified real estate attorney to assist you in structuring any wraparound. You should also contact your tax professional to evaluate tax considerations. Furthermore, an expert in seller-financing can assist in structuring your wraparound.
|Lorelei Stevens is president of Wall Street Brokers, Inc. in Seattle, Washington. She has been a licensed real estate broker (Washington State Real Estate Brokers License WA-LL-SB-*275LD) and a discounted note buyer since the 1970s. She has worked her entire adult life with Wall Street Brokers negotiating millions of dollars of paper and is a nationally recognized expert. |
Lorelei has taught Legal Continuing Education seminars and has written numerous articles for legal, real estate and other professional publications on the subjects of seller-financing, managing, reinforcing and buying paper. She is the author of two books, one on seller-financing and another on note buying. She also writes a monthly column for Noteworthy Newsletter and is a frequent contributor to The Paper Source. Her web site is www.WallStreetBrokers.com.
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