RISING RATES RESULT IN RISING INTEREST IN RISKY WRAPS
Rising interest rates result in a rising interest in risky wrap financing. A wrap may be beneficial to the seller if the current interest rate is high, and the seller’s loan is at a lower rate, as is becoming more common in today’s market. A buyer may consider wrap financing if the buyer cannot qualify for new conventional financing or is seeking to negotiate a lower than market interest rate.
However, there are significant risks with wrap financing for both buyer and seller, especially if the seller’s loan documents contain a due-on-sale clause (also known as an acceleration clause), which requires the loan to be paid off if the property is transferred. Wrap financing also creates substantial risks for the real estate licensees involved in such a transaction.
What is a Wrap?
A wrap is an alternative to the seller paying off or the buyer qualifying to assume the existing loan on the property in a real estate transaction. The seller sells their property to the buyer and agrees to a carryback loan from the buyer for a purchase price that exceeds the seller’s existing loan. The seller does not pay off and the buyer does not assume the seller’s existing loan; the seller remains responsible to the lender for its payment. In other words, the seller “wraps” a larger loan around the existing loan.
Wrap Example: The seller has a home valued at $500,000 that is encumbered by an existing loan with a $300,000 balance and a 3% interest rate. The seller sells the home to the buyer for $500,000, with a $50,000 down payment and finances the buyer with a carryback loan of $450,000 at a 5% interest rate. The buyer makes the monthly loan payments to the seller on the $450,000 loan and the seller makes the payment on their existing $300,000 loan to their lender. The seller also makes a profit on the 2% difference in the interest rates.
Wraps are also referred to as wraparound financing, an all-inclusive deed of trust, or a blanket mortgage.
What are the Wrap Risks for the Seller?
- A Due-on-Sale Clause: Loan documents often contain a due-on-sale clause, and this is almost always the case if the loan is not assumable. If the seller’s loan documents contain a due-on-sale clause, wrap financing is a breach of the seller’s loan documents with serious consequences.
If the seller breaches the terms of the loan documents, the lender is entitled to all available legal remedies, including acceleration of the loan or foreclosure. Simply put, the seller may be responsible for paying their loan in full without the ability to collect the entire amount from the buyer because the seller is obligated to accept monthly payments under the conditions of the wrap financing agreement.
- The Buyer Fails to Make their Payments: The seller is still the primary borrower on the existing loan that was wrapped and is obligated to make the required payments regardless of whether the buyer makes the wrap payments to the seller. If the seller cannot make their existing loan payments without the wrap payments from the buyer, it can result in past due payments to the seller’s lender, lowering the seller’s credit score or even default and foreclosure.
- The Dodd Frank Act: Since the seller is providing the financing in a wrap, the seller should ensure that they are complying with all applicable laws, including the Dodd Frank Act. The Arizona REALTORS® provides Dodd Frank Seller Financing Addendums which may need to be utilized in the transaction.
What Are the Wrap Risks for the Buyer?
- A Due-on-Sale Clause: If the seller’s loan is wrapped in violation of a due-on-sale clause, the seller’s lender may foreclose on the property. Because the wrap loan is in second position behind the seller’s loan, the buyer could lose the property if the seller’s loan is not paid in full.
- The Seller Fails to Make their Payments: Although the seller is responsible for making the payments on the existing loan, the buyer generally has no guarantee that the seller will make these payments. Thus, the property could be foreclosed upon if the seller fails to make payments on the existing loan, even if the buyer has made all their required wrap payments to the seller, because the wrap loan is in second position behind the sellers existing loan.
If the Parties Insist on Wrap Financing
If the parties in a transaction insist on wrap financing, your first step is to talk to your broker or manager. A legal interpretation of the loan to be wrapped is generally outside the area of a real estate licensee’s area of expertise, however your broker or manager can provide guidance on how to handle the transaction.
Second, because wrap financing raises complex issues, buyers and sellers should be advised in writing to consult with independent legal counsel and tax professionals before entering any transaction with a wrap.
Because of the complexities involved in a wrap, the purchase contract must address numerous issues, such as:
- The buyer should request and obtain a copy of the seller’s existing note and deed of trust to review the rights and obligations of the loan agreement. The buyer should confirm that a wrap will not trigger a due-on-sale clause.
- The seller must ensure that the buyer is financially capable of making the required payments. Therefore, the seller should require the buyer to provide financial information to the seller, such as a credit report and income verification and seek professional assistance in interpreting the information, if necessary.
- All payments should be made concurrently through a single servicing account maintained by a licensed escrow agent with adequate instructions regarding forwarding payments. Record-keeping for a wrap loan can be complex. The seller must keep track of the payments made by the buyer and how much of each payment is attributable to principal and how much is attributable to interest. The amount of interest paid must be provided to the buyer for tax purposes. Therefore, the use of a servicing agent in wrap financing, such as an escrow company, is advisable for record-keeping purposes.
How could a lender find out that the loan has been wrapped?
Lenders often discover that a loan has been wrapped by the recording of the transfer of the property, the change of the tax liability, or the change of the insured’s name on insurance policies. Lenders can also become aware of a wrap by receiving payments from the account servicing agent.
Possible Alternatives to Wraps
There may be alternatives to wrap financing depending upon the circumstances, such as:
- Loan Assumption: A loan assumption is when the buyer takes over the seller’s loan and continues to make payments on it. Most conventional loans cannot be assumed because lenders do not allow it with a due on sale clause. However, FHA, VA, and USDA loans may be assumable.
Generally, to assume a loan, the buyer will need to qualify for the loan and will probably incur loan transfer and assumption fees. Additionally, the buyer will most likely have to pay cash (or a seller carryback) to the seller for seller’s equity in the property. A loan assumption is beneficial in that the buyer will inherit the lower interest rate that the seller received when they obtained the loan. Moreover, the term of the loan will likely be shorter than if the buyer were to obtain new financing. In agreeing to a loan assumption, the seller should ensure they are released from any future liability on the loan. The Arizona REALTORS® provides a Loan-Assumption-Addendum that addresses these and other issues.
- Buying Down the Interest Rate: A buyer or a seller through seller concessions, can buy down the buyer’s interest rate on a loan by paying discount points. The cost of the discount point depends upon a variety of factors. Additionally, the buydown can be structured in a variety of ways. The interest rate can be lowered for the life of the loan, a set period of time, or structured in a way that the interest rate gradually increases over time.
- Seller Carryback Financing: Seller carryback financing occurs when all or a portion of the purchase price is financed by the seller. Generally, the buyer will execute a promissory note and deed of trust in favor of the seller, which will be recorded, at close of escrow. This creates an income-producing note for the seller. As mentioned above, The Arizona REALTORS® provides Dodd Frank Seller Financing Addendums which should be used in the transaction.
- Loan Programs Other than Conventional Financing: Non-conforming loans, in other words, loans that do not conform to Fannie Mae or Freddie Mac guidelines, but are government backed, may also be an option. For example:
- FHA Loans: FHA loans may be an option for buyers with lower credit scores or not much money for a down payment. And closing costs may be rolled into the loan.
- VA Loans: VA loan may be an option foractive military, veterans, or surviving spouses. These loans have lower credit score requirements, do not require a down payment, have lower interest rates, and do not require private mortgage insurance (PMI).
- USDA Loans: USDA loans may be an option for lower income buyerspurchasing a home in a qualified rural area. These loans may have a lower interest rate, do not require a down payment, and may have a lower PMI, which may be rolled into the loan amount.
In conclusion, all the parties in a real estate transaction, including the real estate agents, are subject to an increased risk of liability and disputes in a transaction involving wrap financing. Always explore other financing options and consult with your broker or manager before writing a contract that includes a wrap.
For more great articles by Michelle Lind, visit her blog HERE.
Michelle Lind is Of Counsel to the Arizona REALTORS® and the author of Arizona Real Estate: A Professional’s Guide to Law and Practice. This article is of a general nature and may not be updated or revised for accuracy as statutory or case law changes following the date of first publication. Further, this article reflects only the opinion of the author, is not intended as definitive legal advice and you should not act upon it without seeking independent legal counsel. 11/2/2022