Wrap-Around Notes and Mortgages solve many problems. Here’s how they work: Think of a $100,004 house equity as being a pound of sugar in a bag. Suppose Joe and Sam each bought identical houses which were mortgaged at 100% of value. We’ll say that a 14% Note in the amount of $100,000 would be signed by each, representing all 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.
Placing $100,000 debt on the property would be like taking the pound of sugar and putting it into another bag of the same size. The equity ‘bag’ would be inside, and controlled by, the ‘mortgage’ bag. Let’s say that both properties were sold at a time when each had increased in value by $50,000. Let’s assume that at the same time the original mortgage had been paid down to $50,000. Each property equity would once again be $100,000. To make a quick sale, suppose each seller were willing to carry back all them financing by lending the new buyer $100,000 at 12%. So far everything seems equal.
Joe sells his house by carrying back a 2nd Note and 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 has 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 Note and Mortgage in the full amount of the value of the property, which is $150,000. The buyer’s note calls for 12% interest. Sam agrees, solely out of the sums paid in to him by the buyer, to make payments on the underlying loan. If he should fail to do this, he agrees that his buyer can make the payments and deduct them from the payments owed to Sam. 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 owes the original lender $50,000 at 10% and the buyer owes Sam $150,000 at 12%. Disregarding the niceties of mortgage amortization far 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 of $13,000 on his underlying $50,000 equity investments that calculate: out to a 26% return on his capital. Not bad!
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. 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, so Sam will be building equity and increasing his yield monthly.
$500 a month cash flow
The language of Wrap-Around Notes and Mortgages varies a little from that on conventional Notes and Mortgages only because of the requirement that the borrower/maker needs to be protected against Sam’s not making the payments on the first lien. Otherwise, it’s pretty straightforward. About the only thing one might add is an assignment of rents clause to give the tender the right to collect the rents and to apply them to the loan payment in the event the borrower defaults on the loan.