Owner Financing: Three Ways to Structure a Wrapped Contract

When a seller carries a note on a property, and there is an existing mortgage the parties have entered into a transaction referred to as “wrapping” the existing mortgage. The buyer agrees to pay the seller in monthly installments, and the seller pays the underlying mortgage out of the proceeds of the buyer’s payments. However, should the buyer miss or is delinquent in a payment to the seller, the seller is still obligated for the payment to the underlying mortgage since the seller holds the buyer harmless from the mortgage obligations. The seller’s failure to insure the underlying payment is made in a timely manner will affect his credit score, not that of the buyer.

There are a several legal instruments used for wrapping an existing mortgage. They are similar, but not congruent, and their flavor varies from state to state. These instruments are called “Land Contracts”, “Contracts for Deed”, “Note and Deed of Trust”, or “Real Estate Contract.” Check with your attorney (you are using an attorney, aren’t you?) about the instrument that is customary in your state.

Here in New Mexico, we often use a Real Estate Contract. An REC or a Memorandum of REC is recorded giving equitable title to the buyer, but no deed is recorded until the contract is paid in full. The seller remains as the title holder.

Usually RECs are serviced by an escrow agent. In New Mexico servicing the contract is called “escrow,” but in other states it is “account servicing” or even “contract collections.” When the title company closes the transaction, (you are using a title company, aren’t you?), two deeds are created to be held by the escrow agent for the benefit of the buyer and seller. A Warranty Deed is given to the buyer when the contract is paid off. A Special Warranty Deed is released to the seller if the buyer defaults. This is how the seller gets the property back.

Let’s suppose that Sam Seller is selling his house for $100,000. Billy Buyer has $20,000 to put down, but since his credit is bruised, it’s hard for him to get a regular mortgage. Sam’s existing mortgage is just under $60,000. He doesn’t need all of the $40,000 in cash, so he agrees to carry a contract in the amount of $80,000. (We’ll ignore closing costs and broker fees for this example) (You are using a broker, aren’t you?)

For those of you keeping score at home with a calculator, we’ll get precise on these numbers. Sam’s existing mortgage of $59,426.02 at 7{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} at $498.98 per month has 17 years left on it. Here are three different ways to structure this deal.

1. Create one contract in the amount of $80,000.

The early negotiations had suggested a payment of $750 per month at 7.5{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} on the $80,000. The problem is that this note would pay out in less than 12 years, leaving a balance on the underlying mortgage. That would cause problems for every one involved.

Sam and Billy, with the broker’s help, settle on a payment of $694.97 at 7.5{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} for 17 years, which matches the length of the mortgage. After the mortgage payment is made, Sam would pocket about 694.97 – 498.98 = 195.99.

2. Create two separate contracts

Another way to structure the deal is to create two separate contracts. The one in first position would exactly match the terms of the mortgage. This is called a “dollar for dollar” wrap. It would match the mortgage’s balance, interest rate, and payment amount. The second contract would be the difference between the $80,000 and the mortgage balance.

This second contract, if it amortized at the same rate as the mortgage, would have a balance of $20,573.98. At 7.5{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} for 17 years, the payment would be $178.73 per month. Billy’s total payment would be 498.98 + 178.73 = 677.71.

This situation is advantageous for Billy because he get’s the same interest rate as on the mortgage for most of his payment.

3. Different terms on second contract

Sam only wants to collect payments for the next 5 years. So, on that second contract, he asks Billy for shorter terms.

For that $20,573.98 at 7.5{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} for 60 payments, the payment amount would be $412.26. If Billy can afford this payment, it would be great for him because in five years, his payment would go down to $498.98.

However, Billy doesn’t think he can afford the higher payment right now. As a matter of fact, he would like as low a payment as possible. Sam says, OK, we’ll do a 30 year amortization, but you will have to pay off the whole balance in five years. Billy thinks his credit will be better in five years and he’ll be able to refinance, so he says OK. The payment would be 143.86, but the balance would still be $19,466.57 in five years. Billy gets a lower payment, but has the risk of having to come up with a large payoff in five years.