There are many potential buyers who either cannot or do not want to meet the requirements to obtain a new loan from a commercial lender. The reasons for this can range from a recent bankruptcy to investors who are very credit qualified but already own too many properties to obtain additional financing to purchase investment properties.
When a buyer cannot or chooses not to meet the requirement for third party financing from a commercial lender, the most common source of financing is from the seller.
Most property owners have an existing mortgage against the property they are attempting to sell which substantially complicates seller financing. Seller financing with an existing mortgage which will not be paid can be structured as either (1) as wraparound financing or (2) a non-lender approved assumption of the existing mortgage with a second mortgage carried by the seller.
Wraparound Financing. If a seller provides financing and does not pay off the existing mortgage, the seller financing is often structured as “wraparound financing”. Wraparound financing is essentially a glorified second lien. Here is how it works.
Assume an existing mortgage of $100,000 and a sales price of $150,000 with $20,000 paid down and $130,000 of financing provided by the seller.
With wraparound financing the buyer will give the seller a $130,000 note secured by a second mortgage against the property being sold. The mortgage is a second mortgage because the existing $100,000 mortgage is not paid so the mortgage securing the $130,000 financing from the seller is secondary financing behind the $100,000 mortgage. The name “wraparound financing” arises because the secondary financing “wraps around” the existing mortgage.
Non-Approved Assumption. This transaction could be structured as a non-approved assumption with a second lien retained by the seller. The buyer assumes the existing $100,000 loan and gives the seller a second mortgage of $30,000. There is still $130,000 in financing – an assumption of the $100,000 loan and a $30,000 note to the seller.
There are few, if any, lenders who will approve an assumption of an existing loan and if they do, it will be after a full loan application and approval process. If a buyer can qualify to assume, there is usually little reason to assume an existing loan because the buyer can qualify for a new loan. So, if the transaction is to be structured as an assumption, it will almost surely be a non-approved assumption.
When a buyer “assumes” an existing loan, the buyer becomes legally responsible for payment of the loan. The seller is usually not released from responsibility for payment of the assumed mortgage. The buyer is simply added as an additional party responsible for paying the loan.
With a wraparound transaction, the buyer does not assume responsibility for payment of the first mortgage. Instead the buyer gives the seller a $130,000 note. The liability of the seller is the same under either transaction. Either he assumes a $100,000 note and gives a second $30,000 note or he gives a $130,000 note to the seller.
The liability of the seller is the same under either of the two choices. He remains liable for payment of the $100,000 existing mortgage under either scenario.
Due On Sale Provision. Almost all existing loans obtained from a commercial lending source contain a provision commonly called a “due on sale clause”. This is a provision which states that the mortgaged property cannot be sold without lender approval. If a seller sells without obtaining lender approval (which in almost all cases cannot be obtained) the lender can call its mortgage due and foreclose if it is not paid in full.
Most lenders are not currently exercising their rights under due on sale provisions; however, they have the legal right to do so. Anyone contemplating a sale in violation of the due on sale provision in the existing mortgage must be willing to accept the risk that the loan could be called due.
There are ways of reducing the risks of sales in violation of the due on sale clause but a discussion of those methods is beyond the scope of this article.
What Happens Upon Default.
(1) Buyer Defaults Under the Wraparound Mortgage. If the buyer stops paying the wraparound mortgage, the seller has the right to foreclose the wraparound mortgage and regain title to the property.
(2) Seller Fails To Pay The Primary Mortgage. Properly prepared wraparound mortgage documents will give the buyer the right to pay the primary mortgage if the seller fails to pay. If the buyer is required to pay the primary mortgage, he will receive credit against the payment obligations under the wraparound mortgage.
(3) Lender Calls The Existing Loan Due. If the lender elects to call the existing loan due because of a violation of the due on sale provisions, both buyer and seller are at risk because a foreclosure will divest both of them of their interest in the property.
Any foreclosure under the existing loan will impact the seller’s credit because the lender will foreclose the seller’s existing mortgage.
The loan documents can provide that if the existing loan is called due because of a violation of the due on sale provision, the wraparound mortgage can also be called due. The rights of buyer and seller are a matter for negotiation of the parties. However, both parties have a vested interest in making sure the existing loan is not foreclosed because both will lose their interest in the property.