Basic Wrap Around Financing

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Topics: Financing

  

     One variation of Mortgage or Trust Deed is called a Wrap­Around Mortgage (or All Inclusive Trust Deed – A.I.T.D). In effect, these instruments are used to insulate the Buyer from the original loan terms and liabilities. In certain instances the AITD is used to enable the Seller to continue to be the maker of record with the original lender, while at the same time being able to sell the property to another party without triggering a default on an otherwise unassumable Mortgage or Trust Deed.

     At the same time, the Seller can earn additional profits from an interest rate 'spread' between a lower-rate senior lien and a higher rate junior lien he might originate. This is because a mortgage lien originated subsequent to any senior liens 'wraps around' them. Thus, the seller retains the lower interest rate (e.g. 8%) on the original note, while charging a higher interest rate to the Buyer (e.g. 13%). In this way the Seller earns an additional 5% on the original lender's money without any investment of his own money or equity. It's not hard to see why lenders get testy when they encounter this situation. 

     Wrap-Around Notes and Mortgages solve many problems. Here's how they work: Suppose Joe and Sam each bought identical houses which were mortgaged at 100% of value. For purposes of this illustration, we'll ignore down payments and focus solely on the financing terms.

     We'll say that a 10% Note in the amount of $100,000 would be signed by each, representing 100% of the equity in each property. A mortgage or Deed of Trust would be recorded in the public records placing the public on notice that each property is encumbered by $100,000 in the form of a debt lien.

     Think of a $100,000 house equity as being a pound of sugar in a bag. Placing $100,000 debt on that property would be like taking the pound bag of sugar and putting it into another bag of the same size. The inside equity 'bag' would be inside, and controlled by, the outside 'mortgage' bag.

     Let's say that both properties were sold at a time when each had increased in value by $50,000 and when the original mortgage had been paid down to $50,000. Each property's equity would once again be $100,000 as a result of the combination of loan pay down and appreciated value. To make a quick sale, suppose each seller were willing to carry back all the financing by lending the new buyer­$100,000 at 12%. So far everything between the houses is equal.

     Joe sells his house by carrying back a conventional Note and Second Mortgage at 12% which yields $12,000 each year. His buyer is responsible for making the payments on the underlying $50,000 loan that Joe previously signed.

     If the buyer defaults on the payments of the first mortgage, not only is Joe in jeopardy of losing his equity in the 2nd mortgage along with the payments, he's also subject to having a deficiency judgment recorded against any other property he has which is in the public. records. Furthermore, his own personal credit rating can be ruined. Bummer!

     Sam does things a little differently. He has his buyer sign a Wrap-Around Second Mortgage and Note in the full amount of the value of the property, which is $150,000. The buyer's note calls for 12% interest. It states that Sam is obligated, solely out of the sums paid in to him by the buyer, to make payments on the underlying loan.

     If Sam should fail to do this, it further provides that Sam's buyer can make the payments and deduct them from the payments owed to him. If the buyer fails to make payments, Sam can either pay the first mortgage payment and add them to the amount due him, or foreclose.

     At this point, Sam will still owe the original lender $50,000 at 10%, and the buyer will owe Sam $150,000 at 12%. Disregarding the niceties of mortgage amortization for the moment, you can see that each year Sam will pay out $5000 in interest payments to his lender while collecting $18,000 from his buyer. This will leave him a net profit spread of $13,000. $12,000 of Sam's annual interest income will be generated by his equity in the property; and $1000 will be due to his 2% interest rate spread on the difference in what he is paying out and what he is receiving on the underlying $50,000 mortgage debt. That calculates out to a 20% increase in Sam's interest earnings solely traceable to capital invested by a prior lender, not Sam!

     Use of a Wrap-Around Note and Mortgage has done more than increase his return by $1000 over Joe's deal. It has also enabled Sam to control all the payments, which he promised to make' on the first mortgage lien, and to thus protect his equity and credit. Furthermore, Sam will be building equity and increasing his yield monthly. As the years pass, the rate at which this wrap around mortgage amortizes will be much slower than the rate at which the underlying first lien amortizes because of the interest rate differential.

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