Buying an investment property “subject to the existing financing” has appeal for several reasons. Today’s strict mortgage qualification requirements are one of them. If an investor has a blemish on their credit history, he or she will likely be denied a new mortgage for a house they want to purchase. Banks have also tightened their policy on how many investment loans they will approve for investors regardless of an investor’s payment history.
While purchasing “subject to” is a great answer to these obstacles, sellers aren’t always keen being on the hook for the mortgage. They want more security than just a contract saying the buyer will make the monthly payments on the mortgage that is in their name. Investors know that’s where the wrap around mortgage comes in.
Wrap around mortgages provide another layer of security for the seller. Having the investor execute and record a new mortgage positions the seller to be able to foreclose on the property if the investor fails to make the payments. The new mortgage is junior to the first mortgage, which requires the seller to keep the first mortgage current in order to begin foreclosure on the second mortgage.
Let’ put together an example where the seller has an outstanding mortgage of $15,000 on the house and five years remaining on the original mortgage at 5% interest. The investor agrees to buy the house for $100,000 subject to the existing financing with a wrap around mortgage.
As an investor, you have a stake in how much interest the seller is paying on the original mortgage because typically the seller wants the investor to pay a slightly higher rate on the wrap around mortgage. This can be an incentive for the seller to agree to a wrap.
If the seller’s original mortgage is at 5% interest, they may ask the buyer to pay 7% on the wrap. That allows the seller to make 2% interest on their outstanding balance of $15,000 (money they never even loaned out).
Investor’s monthly payment is: $665.30
Seller pays original mortgage payment of: $268.41
Seller pockets the difference of: $396.89
After five years, the seller’s original mortgage is paid off and they pocket the entire $665.30 payment made by the investor.
Both the seller and the investor may want all of the money to flow through a third party escrow account. The seller would require tax and property insurance payments to be escrowed with the monthly mortgage payment. The seller is listed on the insurance policy as “also insured”. On behalf of the buyer, the escrow company makes the original mortgage payment assuring the seller doesn’t fall behind on the payments.
When an escrow account is not used, the seller should insist the investor provides copies of receipts showing the taxes and insurance have been paid. Likewise, the investor should receive a receipt showing the first mortgage has been paid by the seller.
That’s how a wrap around mortgage can be used to convince a seller to sell “subject to the existing financing”. You can discover several alternative ways of creating wrap around mortgages.
Most first mortgages have a “due on sale” clause. However, lenders seldom enforce the clause as long as payments are kept current. In many cases, the first lender isn’t even aware that the house has been sold to a new owner so they have no reason to enforce the clause.
Not all states allow wrap around mortgages. This often involves usury laws that prevent people from earning interest on money they didn’t loan out. Be sure to understand your local laws and regulations before investing with a wrap around mortgage.
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