Wrap- around contract explained

Question: What is a wrap-around contract?

We are looking at buying a home for sale by the owner, and they are offering to sell to us with such a contract.

J.M., Duvall

Answer: Frankly, I would not advise doing a private contract in today’s market because even though mortgage rates have risen from their 2004 lows, they are still very affordable. The only reasons you might want to consider doing a private contract now would be if you cannot qualify for a conventional mortgage or the sellers are offering you a below-market interest rate.

Now, to answer your question:

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 $300,000 and I owe $150,000 on the existing mortgage. I’m willing to take a $30,000 down payment with the balance of the purchase price to be financed on a $270,000 private contract using a wrap-around note. Here’s how it would work:

Let’s assume the payment on my $150,000 mortgage is $850 per month. I would carry back a $270,000 note at an interest rate of 7 percent with payments of $1,796 per month, based on a 30-year amortization schedule. That means I would collect $1,796 from the buyer each month, make the $850 payment on my existing loan, and then pocket the $946 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, income that is unpredictable or difficult to document or both. 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 creditworthy.

That 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 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 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.

But as I said at the beginning, if you are a home buyer and you can qualify for a conventional mortgage, I would not mess around with a private contract. Go to your local bank or mortgage company and get a loan.

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.

Talk to us

More in Herald Business Journal

The tower of Paine Field Airport stands in a fog bank forcing flights to be averted or cancelled in Everett, Washington on January 25, 2022. (Kevin Clark / The Herald)
More 5G-related cancellations as Paine Field fog persists

The FAA has not cleared certain planes to land in low visibility in Everett due to nearby 5G cellular towers.

Funko mascots Freddy Funko roll past on a conveyor belt in the Pop! Factory of the company's new flagship store on Aug. 18, 2017.  (Dan Bates / The Herald)
Despite Arizona move, Everett leaders expect Funko HQ to stay

The toymaker is closing Everett warehouses. But a recent “HQ2” expansion has the city confident Funko will remain rooted here.

2021 survey results from the State Broadband Survey for Snohomish County. (Washington State Department of Commerce)
$16M grant to speed up broadband to north Snohomish County

In Darrington and elsewhere, rural residents have struggled to work remotely during the pandemic. A new project aims to help.

An Alaska Airlines Embraer 175 airplane bound for Portland, Ore., takes off Monday, March 4, 2019, at Paine Field in Everett, Wash. The flight was the first flight on the inaugural day for commercial passenger flights from the airport. Alaska Airlines began scheduled flights Monday, and United Airlines will begin commercial flights on March 31, 2019. (AP Photo/Ted S. Warren)
5G-related airline cancellations arrive at Paine Field

One type of plane serving Everett is subject to restrictions due to feared cellular phone interference with navigation.

FILE - Washington Attorney General Bob Ferguson talks to reporters, Monday, Aug. 26, 2019, during a news conference in Seattle. In a 5-4 decision Thursday, Jan. 20, 2022, the Washington Supreme Court upheld an $18 million campaign finance penalty against the Consumer Brands Association, formerly known as the Grocery Manufacturers Association. Ferguson sued the group in 2013, alleging that it spent $11 million to oppose a ballot initiative without registering as a political committee or disclosing the source of the money. (AP Photo/Ted S. Warren)
Washington justices uphold $18M fine in GMO-labeling case

Big grocers funneled dark money into a campaign against genetically modified labels on food packaging.

In this photo taken May 17, 2017, wine barrels are shown at a vineyard adjacent to the Walla Walla Vintners winery in Walla Walla, Wash. The remote southeastern Washington town of Walla Walla - which used to be best known for sweet onions and as home of the state penitentiary - has now reinvented itself into a center of premium wines and wine tourism. (AP Photo/Nicholas K. Geranios)
More sustainable Washington wines are on the way

Labels will indicate grape growers met guidelines in 9 areas, including water, pest and labor practices.

Funko warehouse in Everett. (Kevin Clark / The Herald)
Funko to close Everett warehouses, shift work to Arizona

The company headquarters are currently in downtown Everett, but distribution will move to a Phoenix suburb.

FILE - In this Monday, March 1, 2021 file photo, The first Alaska Airlines passenger flight on a Boeing 737-9 Max airplane takes off on a flight to San Diego from Seattle-Tacoma International Airport in Seattle. A Boeing pilot involved in testing the 737 Max jetliner was indicted Thursday, Oct. 14,2021 by a federal grand jury on charges of deceiving safety regulators who were evaluating the plane, which was later involved in two deadly crashes. (AP Photo/Ted S. Warren, File)
Alaska Airlines to add Boeing 737s to the Paine Field fleet

It’s a sign of the growing popularity of flying from Everett. So far, much smaller Embraer E175s have been the rule.

A sign bearing the corporate logo hangs in the window of a Starbucks open only to take-away customers in this photograph taken Monday, April 26, 2021, in southeast Denver.  Starbucks is no longer requiring its U.S. workers to be vaccinated against COVID-19, reversing a policy it announced earlier this month. The Seattle coffee giant says, Wednesday, Jan. 19, 2022,  it's responding to last week’s ruling by the U.S. Supreme Court.  (AP Photo/David Zalubowski)
Starbucks nixes vaccine mandate after Supreme Court ruling

The move reverses a policy the coffee company announced earlier this month.

Logo for news use featuring the municipality of Stanwood in Snohomish County, Washington. 220118
Regulators OK doubling of composting operation in Stanwood

Lenz Enterprises can now handle 150,000 tons a year. Residents worry odors will be a problem.

Mara Wiltshire, left, celebrates her first place finish in Mario Cart against her son Miles Jenkins, 7, as Calvin Jenkins, 5, looking on Friday evening at their home in Everett, Washington on January 7, 2022.  (Kevin Clark / The Herald)
Child care’s heightened burden takes parents out of workforce

One Snohomish County mom said she couldn’t return to work “because I didn’t have child care and I wouldn’t be able to afford it.”

Christian Sayre
Everett bar owner arrested again on new sexual assault charges

Christian Sayre, longtime owner of The Anchor Pub, was charged Friday with 10 counts of felony sex offenses.