The "credit crunch" may result in clients who consider creative financing to sell and purchase a home or commercial property. Therefore, we were asked to publish the following excerpt addressing wraparound financing from Chapter 13 of Arizona Real Estate, A Professional's Guide to Law and Practice.
Wraparound financing is also referred to as a wrap, an all-inclusive deed of trust or a blanket mortgage. Wraparound financing occurs when a seller sells property that is already subject to an existing loan and takes back a loan for a purchase price that exceeds the existing first loan. The face amount of the carry back loan includes the remaining principal on the 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.
A wrap is an alternative to paying off or qualifying to assume an existing loan. A warp may be beneficial to the seller if the current interest rate is high and the first loan is at a lower rate. A buyer may consider wraparound financing if the buyer cannot qualify to assume the existing loan encumbering the property or qualify for new financing.
Question: Is wraparound financing legal? Although statutes in some states may prohibit wraparound loans, Arizona has no statute pertaining to this type of financing. However, if the loan documents forbid the loan from being wrapped, i.e. with a due-on-sale clause, an agreement to wraparound financing will result in a breach of the loan documents (which generally consist of a promissory note and deed of trust). If the seller breaches the terms of the loan documents, the lender will be entitled to all available legal remedies, including acceleration of the debt or foreclosure. Simply put, the seller may be responsible for paying the 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 carry back.
Question: Should wraparound financing be used if the loan encumbering the property contains a due-on-sale clause? No. Wraparound financing should only be considered when the seller's existing loan documents do not contain a due-on-sale clause. If the seller's loan contains a due-on-sale clause, the seller is contractually obligated to pay off the outstanding balance on the existing loan when the property is sold. In rare cases the lender may consent to a wraparound when it is in their best interest to do so.
Question: May a non-assumable loan be wrapped? If the loan is not assumable, the loan documents generally contain a due-on-sale clause that the lender could use to call the loan due. Therefore, if the loan is not assumable, the loan should not be wrapped.
Question: What are some lenders' concerns with wraparound financing? Many lenders do not want their loans wrapped, especially if the first loan has a below-market interest rate. From a business standpoint, lenders want to earn the highest rate of return possible. Additionally, lenders generally consider wraparound financing a high-risk transaction because the buyer oftentimes cannot qualify for a new loan.
Question: 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 agents.
Question: What are some buyer's concerns with wraparound financing? The buyer must ensure that the first loan is timely paid. With a wrap, the seller does not pay off the first loan, and the lender retains the right to foreclose on the property of payments are not made as required. Although the seller is responsible for making the payments on the first 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 first loan. Therefore, a buyer should insist that all payments be made concurrently through a single servicing account maintained by a licensed escrow agent with adequate instructions regarding forwarding payments.
Question: What are some seller's concerns with wraparound financing? 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 credit report and income verification and seek professional assistance in interpreting the information, if necessary. The seller's credit status can also be in jeopardy if the buyer fails to make their payments timely, as the seller is still the primary borrower on the note and deed of trust that was wrapped.
Question: Should a buyer considering a wrap request a copy of the seller's loan documents? Yes. The buyer should request and obtain a copy of the note and deed of trust to review the rights and obligations. The buyer should confirm that a wrap would not trigger a due-on-sale clause, which requires the loan to be paid off if the property is transferred.
Question: What kind of record-keeping is needed with wraparound financing: The record-keeping for a wraparound mortgage 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 purpose. Therefore, the use of a servicing agent, such as an escrow company, is advisable for recordkeeping purposes.
Question: Do real estate brokers incur more liability in a transaction utilizing wraparound financing? Yes. Wraparound financing is risky for all parties involved. Additionally, because of the complexities involved in such a transaction, the purchase contract must adequately address numerous issues.
Question: Should buyers and sellers be referred to legal and tax counsel before agreeing to wraparound financing? Yes. Because wraparound financing raises significant and complex issues, buyers and sellers should consult with independent legal counsel and tax professionals before entering into any transaction with a wrap.
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