Wraparound mortgages are one of the most powerful, yet underutilized, strategies in real estate investing. If you want to boost your profits while minimizing your liabilities, understanding wraparound mortgages is essential. Let’s dive into how they work, why they’re so effective, and how you can apply them successfully.
What is a Wraparound Mortgage?
A wraparound mortgage is a type of financing where you create a new loan that “wraps around” an existing one. Essentially, it involves financing someone at a higher price or payment rate than the underlying lien. This underlying lien could be anything from a mortgage you’ve taken over “subject to” existing financing or private money loans.
How It Works
Imagine you take over a property with an existing $80,000 mortgage at 5.25% interest with 22 years left. You then sell this property to a new buyer at a higher price—say $90,000—at a higher interest rate of 9.5% for 30 years. The new buyer’s payment will be higher than what you owe on the original mortgage, and the difference becomes your profit.
Why It’s Profitable
The profitability of wraparounds is rooted in the concept of arbitrage—making money on the difference in interest rates and terms. For instance, the new buyer’s payment might be $756.77 while your outgoing payment to the existing mortgage is $511.59. That $245.18 difference is your monthly cash flow.
Keys to Making Wraparounds Work
Importance of Good Contracts
Having solid contracts is crucial. In Texas, Horne & Associates are highly recommended for their expertise in this area. The contracts ensure that all legal aspects are covered, reducing your risk.
Prerequisite Knowledge
Before diving into wraparounds, it’s important to understand key concepts in owner financing, Dodd-Frank regulations, the 10B2 calculator, and subject-to transactions. These will give you the foundational knowledge needed to navigate this complex investment strategy.
Mindset for Understanding Numbers
Repeat after me: “I love numbers, and numbers love me.” Embracing this mindset is crucial because wraparounds involve a lot of calculations. Understanding how these numbers work will directly translate into dollars in your pocket.
Visualizing a Wraparound Scenario
The Wrapped Debt
Consider an $80,000 loan at 5.25% interest with 22 years remaining, resulting in payments of $511.59 per month. When you sell the property with a wraparound mortgage for $90,000 at 9.5% interest over 30 years, you get payments of $756.77 per month. The difference between these payments is your cash flow.
Longer Terms
One key advantage of wraparounds is that you typically set longer terms for the new loan. For example, your original loan might have 22 years left, but you sell the property with a 30-year term. This creates a longer period of cash flow and greater overall profit.
Wraparounds as a Sales Strategy
Wraparounds are primarily used for selling properties, not buying. Buying with a wraparound can result in losing potential income. Conversely, selling with a wraparound maximizes your profits.
Buying with Subject-to vs. Wraparound
Subject-to Approach
When you buy a property subject-to, you’re essentially taking over the existing mortgage without formally assuming it. This means you’re responsible for the payments, but the mortgage stays in the original owner’s name.
Financial Comparison
For example, if a property sells for $90,000 and has an existing $60,000 loan at 3%, the seller wants the contract to reflect $90,000. If you buy with a wraparound at $90,000 and 6% interest for 15 years, you’ll pay $759.47 per month. Alternatively, if you buy subject-to, you might only pay $667.51 per month. Over time, this approach can save you nearly $17,000.
Selling with a Wraparound
Example Scenario
Let’s say the original $80,000 loan has 22 years left with monthly payments of $511.59. You sell the property for $100,000, take a $10,000 down payment, and finance the remaining $90,000 at 9.5% over 30 years, making the new buyer’s payment $756.77 per month.
Long-Term Profits
For the first 22 years, you collect $245.18 per month. Once the original loan is paid off, you collect the full $756.77 per month for the remaining 8 years. This strategy can net you over $140,000 in total profits from a property with only $20,000 in equity.
Benefits of Being the “Bank”
When you finance a property, you essentially become the bank. This means you don’t have to deal with maintenance or repairs. Your responsibility is limited to ensuring the payments come in. If the buyer fails to pay, you can foreclose and potentially earn even more.
Tips and Considerations
Prefer Principal Over Interest
When structuring deals, aim for higher principal amounts rather than higher interest rates. This is because principal is guaranteed to be paid off if the buyer sells or refinances.
High Interest on Underlying Debt
Even if the underlying debt has a higher interest rate, it’s okay as long as your sales price justifies it. For example, a $64,000 loan at 9.5% can still be profitable when wrapped at $90,000 at 9% interest.
Buyer Pays Closing Costs
Always have your buyer pay all closing costs, including attorney fees and title search. This is standard practice in owner financing.
Qualify Buyers Properly
Use a Residential Mortgage Loan Originator (RMLO) to properly qualify your buyers. In Texas, Texas Pride Lending is a great option. Make sure to retain these records for at least five years to adhere to Dodd-Frank regulations.
Key Takeaways
In conclusion, mastering wraparound mortgages can significantly enhance your real estate investing strategy. By leveraging the differences in interest rates and loan terms, you can create substantial cash flow and long-term profits. Remember, the key to success lies in understanding the intricacies of owner financing, crafting solid contracts, and effectively managing numbers.
As you delve into this powerful strategy, ensure you have the right mindset and knowledge base to navigate its complexities. With careful planning and execution, wraparound mortgages can be a highly profitable addition to your investment portfolio, allowing you to maximize returns while minimizing risks.
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