A seller-financed note that wraps an existing low-rate mortgage, priced as what it really is: a leveraged position in the seller's own note.
The seller earns the wrap payment less the underlying loan's payment, on the equity left in the note. On an illustrative $225,000 wrap at 8 per cent over a $140,000 mortgage at 4 per cent, the seller keeps $912.00 a month on $85,000 of equity: a 13.82 per cent yield if the buyer pays off in year 7, against 8.00 per cent on a straight note at the same rate.
Worked in full in The Mortgage Note Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A wraparound mortgage is a seller-financed note that leaves the seller's existing loan in place. The buyer pays the seller on a new, larger note; the seller keeps paying the old lender out of it. When the old loan carries a lower rate than the market, the wrap lets the seller lend at today's rate while borrowing at yesterday's. That makes it a leveraged position, and it should be priced as one, with the leverage's risk named.
| Item | Value |
|---|---|
| Sale price | $250,000 |
| Buyer's down payment | $25,000 |
| Wrap note: balance, rate, term | $225,000 at 8.00%, 360 months |
| Underlying mortgage: balance, rate, months left | $140,000 at 4.00%, 300 months |
| Assumed payoff by the buyer (sale or refinance) | Month 84 |
Payment = balance × r / (1 − (1 + r)−n), r the monthly rate
Wrap: $225,000 at 8.00 per cent over 360 months = $1,650.97. In Excel: =PMT(8%/12, 360, -225000).
Underlying: $140,000 at 4.00 per cent over 300 months = $738.97.
Spread = $1,650.97 − $738.97 = $912.00 a month, $10,943.98 a year, until the underlying loan is repaid.
The seller's equity in the house was $110,000. The buyer's $25,000 down payment takes $25,000 of it out in cash; the remaining $85,000, the wrap balance less the underlying balance, is what the seller has lent. It is 37.8 per cent of the note.
Look at the first month's interest to see where the return comes from. The seller receives $1,500.00 of interest on $225,000 and pays $466.67 on $140,000: $1,033.33 net. Of that, $566.67 is 8 per cent on the seller's own $85,000. The other $466.67 is the 4-point rate gap on the $140,000 the seller borrowed cheaply years ago. That second piece is the leverage, and it is why the yield on the equity exceeds the note rate.
Flows: −$85,000 at month 0, +$912.00 a month, plus (wrap balance − underlying balance) at payoff
At month 84 the wrap balance is $208,074.22 and the underlying balance $113,653.37, so the payoff nets the seller $94,420.85. The IRR of these flows is 13.82 per cent, an annual rate compounded monthly. In Excel: =RATE(84, 912, -85000, 94420.85)*12.
If the buyer never pays off, the seller collects the $912.00 spread for 300 months and then the full $1,650.97 for the last 60, $372,658 in all, 4.38 times the equity: a yield of 12.80 per cent. The payoff case yields more because it captures only the years when the cheap underlying loan, the source of the leverage, is still large. Held to maturity, the underlying amortises away and the last 60 months earn just the 8 per cent note rate.
| Underlying rate | Underlying P&I | Monthly spread | Yield on $85,000 |
|---|---|---|---|
| 3% | $663.90 | $987.07 | 15.12% |
| 4% | $738.97 | $912.00 | 13.82% |
| 5% | $818.43 | $832.54 | 12.46% |
| 6% | $902.02 | $748.95 | 11.03% |
| 7% | $989.49 | $661.48 | 9.55% |
The lever works both ways. Each point on the underlying loan moves the seller's yield by roughly 1.3 to 1.5 points. With the old loan at 7 per cent, the wrap earns 9.55 per cent: barely more than a straight note, with all the extra risk below still attached.
A note investor buying the seller's position values the net flows, not the gross note. At a 10 per cent required yield and a month-84 payoff, the seller's position is worth $101,959.97, 120.0 per cent of the $85,000 of equity: the spread is real value, provided the risks above are priced in the required yield.
A wrap is a seller-financed note with a cheap loan inside it. Price the spread on the equity, $912.00 a month on $85,000 here, and the yield is 13.82 per cent rather than the 8 per cent on the face of the note; then charge for the due-on-sale and default risks that come with it. Choosing the wrap rate itself is the subject of what interest rate to charge on seller financing. The Mortgage Note Investor prices performing owner-financed notes at any required yield, and the free workbook for the book's performing note does the same with the price, the costs and the default overlay as inputs.
Subtract the underlying loan's monthly payment from the wrap note's payment. A $225,000 wrap at 8 per cent over 360 months pays $1,650.97; the $140,000 underlying loan at 4 per cent with 300 months left costs $738.97. The seller keeps $912.00 a month, $10,943.98 a year, until the underlying loan is repaid.
Because the seller's money in the note is only the wrap balance less the underlying loan, $85,000 of $225,000 here, yet it earns 8 per cent on the whole $225,000 while paying 4 per cent on $140,000. In month one that is $566.67 of interest on the equity plus $466.67 from the rate gap. The result is 13.82 per cent with a payoff in month 84.
Most conventional mortgages carry a due-on-sale clause. If the lender enforces it, the seller must repay the underlying balance, $136,671.76 after a year in this example, from its own cash or a refinance, while still owing the buyer the wrap terms. That risk belongs in the price: take legal advice on the clause before structuring a wrap.
This article is one calculation from The Mortgage Note Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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