What it means
Suppose a seller has a property with an existing mortgage at a low interest rate. Instead of repaying it from the sale proceeds, the seller agrees to finance the buyer with a new, larger loan that "wraps around" the old one.
The buyer pays the seller each month, and the seller uses part of that money to pay the original lender. The seller usually charges a higher rate on the wrap-around loan than the rate on the underlying loan.
The difference, applied to the overlapping balance, is extra profit for the seller. For example, the seller earns the full interest rate on the larger loan but pays the lower rate only on the smaller one.
The buyer benefits from easier access to credit, often with a smaller down payment and fewer formalities than a bank loan. The seller benefits from a steady income stream and from a sale that might not otherwise happen.
Both sides need clear legal documents, because the arrangement involves three parties and two loans. The main risk is the due-on-sale clause in many original loans, which allows the first lender to demand full repayment when the property is transferred.
If the lender does so, the seller may have to repay quickly, and the buyer could lose the property if the seller cannot. Both sides should take legal advice and, where possible, get the original lender's consent.
The nuance is that the buyer depends on the seller to keep paying the original lender. If the seller fails to pay, the first lender can foreclose even though the buyer has made every payment, so the buyer should check payments directly or use a third party to collect them.
Tax and accounting treatment needs attention on both sides. The seller may be able to spread the gain on the sale over the life of the loan under instalment sale rules in some places, and interest received and paid is reported separately.
The buyer usually treats the full wrap-around loan as its liability, so the balance sheet shows the larger amount even though the seller owes less to the original lender.
In practice
Real-world examples.
Example
A property owner wants to sell a small office building but buyers struggle to get bank loans. The owner offers a wrap-around loan, keeping the existing low-rate mortgage in place and earning a spread on the new loan.
Example
A buyer with irregular income but a strong deposit cannot meet a bank's requirements. A seller agrees to a wrap-around loan with a five-year term, after which the buyer plans to refinance.
Example
An investor in rental properties uses wrap-around loans to sell units to tenants. The investor documents each loan carefully and uses a servicing company to collect payments and pay the original lender.
Formula
Calculation
Seller's annual net interest = (wrap-around balance x wrap rate) - (underlying balance x underlying rate)
Suppose a seller sells a property for $300,000. The buyer pays $50,000 as a down payment, leaving a wrap-around loan of $250,000 at 7%. The seller's existing mortgage has a balance of $200,000 at 4%. Interest received = 250,000 x 0.07 = $17,500. Interest paid = 200,000 x 0.04 = $8,000. Net interest income = 17,500 - 8,000 = $9,500 a year.Case study
Seen in the real world.
Hollis Street Properties is an illustrative, fictional company that owned a small apartment block with a $1,200,000 mortgage at 3.5%. Market rates had since risen to 7%, and potential buyers struggled to afford a new bank loan.
The company agreed a sale price of $1,800,000. The buyer paid $300,000 up front and took a wrap-around loan of $1,500,000 at 6.5%, with a five-year term. Hollis Street earned $97,500 in interest a year on the wrap loan, against $42,000 it paid on the original mortgage, giving a net $55,500.
The sale went ahead and the company obtained the lender's written consent to avoid the due-on-sale problem. In this illustrative case the spread added a steady income, though the company remained at risk if the buyer defaulted.
Watch out
Common mistakes.
- Overlooking the due-on-sale clause in the original loan, which can trigger a demand for full repayment.
- Buyers assuming that payments made to the seller are always passed on to the original lender.
- Calculating the seller's profit on the whole wrap-around balance, when the cost applies only to the smaller underlying balance.
Questions
People also ask.
Why would a seller offer a wrap-around loan?
It can allow a sale that would otherwise fail, and it can earn a profit from the gap between the two interest rates.
Is a wrap-around loan legal?
It is permitted in many places, but legal and tax rules differ, so both sides should obtain independent advice.
How can the buyer reduce the risk?
The buyer can use a servicing company or escrow to make payments to the original lender directly and can insist on written lender consent.
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