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So, you want to buy an investment property, but you can't qualify for a mortgage product through a traditional lender. It's not as uncommon of a problem as you might think. There are hundreds of thousands of people in the U.S. that can't qualify for a traditional mortgage for various reasons including the lack of employment income verification from a W-2 or 1099. If you're an investor without a W-2 or 1099 job, most traditional lenders won't even look at you.
Whether you're looking for a long-term buy and hold to add to your rental portfolio, or a fix and flip property, one way you can buy real estate without qualifying for a traditional loan is through a wrap-around mortgage. Let's take a look at this process.
A wraparound mortgage, also known as a carry-back loan, is a form of owner or seller financing in which the buyer gets a mortgage that includes, or "wraps around," the existing mortgage the seller has on the property. The buyer makes one payment to the seller, which the seller uses in part to pay the first mortgage, and then pockets the remainder. In many cases, the wraparound mortgage will have a higher interest rate than what the existing mortgage had, so the seller can cover the payment and also profit.
Seller Financing & Wraparound Mortgages
Let's start with an example for which the property we're looking at doesn't have a loan on it. You've offered $100K, but the seller wants $150K. But the seller owns the property free and clear and they're not selling it for anything less than $150,000.
At this point, we take a look at doing this deal with Seller Financing.
This funding strategy is also known as owner financing or seller carryback. Here's how this one works… The seller acts as the bank, that's their role in this deal. They place a lien on the property at the close of escrow. The terms of your note are whatever you and the seller agreed to.
Seller wants $150,000.
I ask the seller how much they think it will rent for. He says: $1,500/month.
If we did a rent-to-own, we could likely get a down payment of $2,500 to $7,500 (maybe even more), plus the rents as the option deposit.
Knowing this info, you'll then go to the seller to negotiate:
“What if I paid you, Mr. Seller, $100K cash OR I could talk to my business partner, who might be willing to figure out some creative financing options. I'm thinking that we could do a loan, where you carry back the paper. Would that be something you're interested in? I mean, I do have to work it out with my partner and we'd have to structure the deal a certain way, but if you're interested, we're willing to put in the time and energy to see what's the best creative solution we can come to, so you are able to sell for $150K.” See, not only do you have to consider your seller in this situation; you also have to think about your competition from other investors. We know the seller wants $150K, and let's say 3 other investors have come in and offered $130K or $140K – but you outmaneuver your competition by swooping in, and through creative financing, you're able to offer $150K.
Who's the seller going to play ball with?
Wrap-Around Agreement Elements
Wrap-around mortgages, also known as "wraps", provide sellers greater assurances when engaging in seller-financed agreements. The structure of the wrap must include the agreed purchase price, the down payment, and the accompanying bank-financed loan. The bank loan is obtained by the buyer and is used to pay the existing mortgage held by the seller.
On the surface, wrap-around agreements can seem risky for sellers. It is much easier to have a buyer finance and pay the complete purchase price at escrow's close. In traditional purchase agreements, sellers walk away cleanly from the property.
In a wrap, the seller remains tied to the property for the duration of the agreement. However, there are some benefits worth the risk to sellers.
Wraps are attractive to buyers who may not qualify for traditional lending options. Thus, sellers open the buying market to buyers who might not otherwise look at their home. Wraps additionally reduce annual income tax liabilities by extending income and profit over time. Some lenders also like wraps because they back an existing, maturing note usually with a lower interest rate.
Writing the Wrap
Check with local state mortgage laws to confirm wrap-around mortgages are allowed in your state. The S.A.F.E. Act set restrictions on loans nationwide. According to the S.A.F.E. Act, anyone writing a mortgage must have a mortgage license. A lender, including a seller-financier, violates the S.A.F.E. Act if he is not licensed through the Nationwide Mortgage Licensing System (NMLS).
Obtain the required forms either online, or through a real estate deed conveyor's office. Forms include the Wrap Around Financing Addendum, warranty deed, deed of trust promissory note and disclosures. Review all details of the wrap including a reasonable, industry-accepted interest rate. Check with state and federal lending regulations for compliance.
Sign all forms in front of a notary. In the documents, include a Dodd-Frank compliance disclosure that acknowledges the seller has not sold another property with a wrap-around mortgage in the previous 12 months.
The Dodd-Frank Act creates an exception, allowing individuals to set up one seller-financed transaction per year. This exception is not nationwide, so check with state regulations to see if Dodd-Frank provides an exception in your state.
After the Sale
Generally, a wrap-around installment agreement is shorter than a traditional 30-year loan. At the end of the term, sellers usually won't extend the wrap. Sellers expect buyers to finalize all payments at the end of the wrap term. Thus, buyers need to either refinance with traditional mortgage products or make a balloon payment to fulfill the wrap-agreement.
Each year, the buyer will furnish the seller with a 1098 to report the income on his tax return.
The Bottom line
A wraparound mortgage is a creative way for a buyer and seller to facilitate a transaction, but there are risks on both sides. Buyers will need to find the right seller who's willing to work with their situation. Options might include a seller who's having a difficult time unloading their home or one who's facing the consequences of an inability to pay their mortgage.
Once you find the property you want and an agreeable seller, the original lender will need to be contacted for approval, as well. Before moving forward with a wraparound mortgage, it may be wise to consult with a real estate attorney who can advise you on the risks.