Legal advice important in any private contract deal

Q We are looking at buying a home that’s for sale by the owners, and they are offering to sell to us on a wrap-around contract. What’s that?

J.M., Duvall

A As the term implies, a wrap-around contract is a type of financing where the seller carries back a private note that wraps around the existing mortgage on the home.

For example, let’s say I’m selling a house for $250,000 and I owe $150,000 on the existing mortgage. I’m willing to take a $25,000 down payment, with the balance of the purchase price to be financed on a private contract using a wrap-around note.

Here’s how it would work:

Let’s assume the payment on my current $150,000 mortgage is $850 per month. I would carry back a $225,000 note at an interest rate of 7 percent with payments of $1,497 per month, based on a 30-year amortization schedule. That means I would collect $1,497 from the buyer each month, make the $850 payment on my existing loan and pocket the $647 difference. The existing mortgage would stay in place and my private note would wrap around it.

Note that the interest rate on the wrap-around note is slightly higher than the going rate for a conventional loan. That’s because a private note carries more risk. Buyers looking for seller financing often have poor credit and/or income that is unpredictable or difficult to document – that’s why they can’t get a loan from a bank. If I’m going take more risk than the bank, I deserve to be paid a higher interest rate for my trouble.

Just keep in mind that the interest rate charged on a wrap-around note, or any private contract, is subject to negotiation between the buyer and seller. In some cases, the seller might want to offer below-market rate financing. Why? Maybe the seller is retiring and they just want an ongoing income stream rather a lump sum of cash. By offering a below-market rate, there is less chance you will pay off the loan early.

Also notice that the payments on the wrap-around note are based on a 30-year amortization schedule in order to keep the monthly payments low. In the real world, sellers are rarely willing to carry a private contract for 30 years, so there is typically a balloon payment clause in the note.

For example, the remaining balance on the note might be due and payable in full on the fifth anniversary of the note. That’s called a five-year balloon note. As the seller, if my goal is to be cashed out as soon as possible, I would make the balloon period short (e.g., three years). But if I’m carrying the note as a means of generating extra retirement income, I would make the balloon period long (e.g., 10 years), or I might not have any balloon payment clause at all.

I might instead have a 30-year note with a due on sale clause that would require the buyer to pay me off if and when the house is sold in the future. That’s because I’m carrying the contract based on the creditworthiness of the person buying my home. I don’t want to let the buyers have some stranger assume the loan and take over the payments because I have no way to know whether the new buyers are credit worthy.

Which brings up the problem of the due on sale clause on the existing mortgage on the home. Placing a wrap-around loan on a home will trigger the due-on-sale clause on the current mortgage – but only if the lender finds out about it. The reality is that many buyers take title to a home subject to the existing mortgage on the property.

The payments continue to be made each month, either by the seller or the new owner of the home. As long as the lender receives the proper payment each month, nothing happens. However, if the lender finds out that the property has changed hands – usually in a notification from the insurance company of a new name on the homeowner’s policy – the entire remaining balance of the loan can be called due and payable. That’s a risk the buyer and seller take whenever there is a private note wrapped around a conventional loan containing a due on sale clause. I’m not making a value judgment here, just stating the facts.

Sellers using a wrap-around note, or any kind of private financing, should also include a prepayment penalty clause in the note if their goal is long-term income. One of the tricks of the trade used by unscrupulous real estate investors is to convince a seller to settle for a low price based on a private contract with a very high interest rate.

The investor emphasizes how much money the seller will earn over the life of the loan in exchange for taking a lower sales price today. Unfortunately, many of these sellers see their expected income stream dry up when the investor quickly turns around and refinances the property at market rates and cashes out the seller.

To prevent this from happening, the note should include a stiff prepayment penalty that makes it very expensive for the buyer to pay off the loan during the first few years.

Seller financing can be a win-win situation for both the buyer and seller as long as everyone fully understands and agrees to the terms of the contract. But it is not a wise way to go for novice home buyers who don’t have the real estate knowledge to know if they are getting a good deal. Any time seller financing is involved in a real estate transaction, I strongly recommend having all documents reviewed by an attorney before you sign them.

Mail your real estate questions to Steve Tytler, The Herald, P.O. Box 930, Everett, WA 98206. Fax questions to Tytler at 425-339-3435, or e-mail him at economy@heraldnet.com.