Finance Definitions: Wraparound Financing

When I think about wraparound anything, the first thing that comes to mind is a wraparound porch. My grandmother had one, and it was a thrill as a child to chase my younger cousins all the way around the house to end up right where we started. Ah, memories…but I digress. What we’re talking about today is wraparound financing, not wraparound porches. But I promise, the porch will come in handy as an analogy. Got you hooked? Well, let’s take a look!

Wraparound Financing at its Finest

Okay, so onto the analogy: wraparound financing is very similar to a wraparound porch. The porch serves to wrap around the house. In essence, it gives the house a big old hug. In the same light, a wraparound loan hugs another loan. It wraps around an existing loan to encompass all of the loan’s value, the APR and the payments.

In more technical terms, wraparound financing exists when a loan is taken out on top of an existing loan to pay off the existing loan through monthly installments. When explained that way, though, it doesn’t make much sense, so let’s look at an example using a common wraparound financing option, the wraparound mortgage.

The Wraparound Mortgage Example

Let’s say that the Smiths have been trying to sell their home for a while. The home is worth $200,000, and the Smiths owe $150,000. A potential buyer (Jones) comes along and offers $200,000. The Smiths are thrilled, but Jones cannot obtain a traditional mortgage because of a bankruptcy. So the Smiths offer to loan Jones the money at an interest rate higher than their own and at payments higher than their own. Both parties also agree to a $5,000 down payment, and the deal is struck.

Now for the nitty-gritty details: let’s say the Smiths owe ABC Bank $1,000 per month and that their interest rate is 4.5%. The Smiths could build in some leeway by charging an interest rate of 10% to Jones with a monthly repayment of $1,300 per month. This allows the Smiths to collect Jones’ payment, pay their $1,000 monthly payment, and bank $300 per month. The Jones’ loan is big enough to wrap around their own loan and give them a little safety net.

What are the Negatives?

Of course, as in any financing deal, something could always go wrong. For wraparound financing, some of the negative aspects include: the seller is lending to a high-risk individual and the buyer could fail to make payments at any time; the seller must often work out a deal with or get permission from the current mortgage holder in order to offer wraparound financing to the seller; the seller’s purchase of a new home may be affected be the need to carry the existing mortgage on their credit report; and the buyer must wait until the loan is paid in full to receive the deed to the property.

Overall, wraparound financing could help sellers sell and buyers buy, but there are some risks. It’s important to weigh these risks before buying or selling through a wraparound financing option.

MomVesting readers, have you ever taken part in a wraparound financing deal? How did it work out for you?

Photo Source