The 10 Biggest Wrap Note Mistakes We See (and What to Do Instead)

Not all wrap note mistakes are equal. Some reduce profits. Some create headaches. A few can put the entire transaction at risk.

We see a lot of wrap notes as investors, usually involving seller financing. The seller still owes money on the property and the owner financing ‘wraps’ around an existing mortgage. The buyer pays one payment to the seller while the seller continues to pay the underlying loan.

It’s easy to see the allure. Who doesn’t want to find a way to keep those golden 3% mortgage loans at work? Shoot, even a 5% mortgage looks pretty appealing with rates currently averaging 6.5% for a 30-year loan. If you can wrap a 3% existing mortgage with an owner-financed note at 9%, you have created a 6% spread.

For a simplified example:

• $100,000 at 3% for 30 years equals a principal and interest payment of $421.60
• $100,000 at 9% for 30 years equals a principal and interest payment of $804.62

That’s a $383.02 monthly cash flow in interest spread using a wrap note!

The first wrap mortgage I saw was back in the 1980s. Rates were in the teens, and wrapping anything under 10% looked very attractive.

But what looks good on paper can create risks in real life.

Wrap notes can be a powerful tool when used correctly. Unfortunately, we see the opposite a lot. The wrap itself does not cause most wrap failures — they stem from decisions made before and after the closing table.

From the dumpster on fire to the messy middle, here’s my take on the Top 10 Wrap Note Mistakes, broken down into three main categories. If you are new to wraps and want to wade into the shallow end first, you can read my article on “What Is A Wrap Note.”

In This Article:

• Wrap Mistakes That Create Legal and Liability Problems (CLICK HERE)
• Wrap Mistakes That Create Management Problems (CLICK HERE)
• Wrap Mistakes That Create Structural Problems (CLICK HERE)

Wrap Note Mistakes That Create Legal and Liability Problems

Mistake #1 – Failing to Disclose the Risks Fully

There are risks to both buyers and sellers with wrap notes.

The seller is still obligated as the borrower on the underlying 1st lien, and that debt still appears on their credit report. If the buyer on the wrap note defaults, the seller will need to come out of pocket to maintain the first lien and avoid default or, worse, foreclosure.

The buyer is tied to the seller’s actions and circumstances. They need to have their payment on the wrap used to pay the first lien. The wrap seller could go into bankruptcy or pass away. The buyer may have trouble accessing the first lien because the lender may not recognize its involvement in the transaction. There could be escrows, PMI, and insurance complications.

And for both parties, there is the risk that the “Due-on-Sale” clause will be enforced, under which the first-position lender has the option to call the balance due when the property transfers ownership.

Most disputes don’t start because someone was intentionally dishonest. They start because someone thought everyone understood the risks.

Wrap Mortgage Tip #1 – Disclose, Discuss & Acknowledge

Wrap risks need to be disclosed, discussed, and acknowledged in writing by both the buyer and the seller. There are many states, such as Texas, Arizona, and California, that have specific disclosures for the All-Inclusive Trust Deed (AITD) or wraparound mortgage.

Mistake #2 – Having No Plan for the Due-on-Sale Clause

Picture this: the lender has sent a letter demanding that the loan be paid off. What will you do? You need to have a worst-case scenario exit strategy prepared. Hoping the lender never notices is not an exit strategy.

• Can the buyer/wrap borrower refinance to pay off the wrap loan (that will in turn payoff the first lien)?
• Can the property be sold for a profit by the buyer/wrap borrower to pay off the loans?
• Can the seller sell their wrap note to pay off the first lien and keep collecting payments from the seller?
• Can the wrap seller borrow against their wrap note to pay off the first lien?

Wrap Mortgage Tip #2 – Create a Note with Resale Value

Create a note that is marketable to a note investor. Pay attention to factors such as the down payment, credit history, ability to repay, documentation, and note terms, which can make the note more valuable to an investor. The note can then be sold, and the underlying first lien paid off from proceeds at closing. Paying off any underlying lien is the #1 way note buyers eliminate wrap risk.

Mistake #3 – Getting the Insurance Wrong

While the Due-on-Sale risk gets the most attention, its insurance issues seem to occur most frequently. Property insurance is tricky and complicated on wrap notes. Lapsed insurance, dual coverage, force-placed insurance, inadequate coverage, and dealing with multiple parties on claims can all cause issues with serious financial repercussions.

I’ve seen more wrap transactions experience insurance problems than due-on-sale enforcement. Ask me about the pink house: frozen pipes, Niagara Falls down the circular stairway, and getting a lender to sign off on an insurance check for repairs when I bought on a wrap but wasn’t on the loan.

Wrap Mortgage Tip #3 – Check the Insurance

Keep property insurance current, ideally through escrows. Be sure the policy properly identifies and protects all parties involved. Insurance is an area where I strongly recommend getting professional guidance. A conversation with a knowledgeable insurance agent can prevent a very expensive problem later. Many providers recommend that the policy identify the:

• Buyer listed as insured
• Seller listed as additional insured
• Existing lien holder listed as first mortgagee

Mistake #4 – Using Generic & Incomplete Paperwork

This is not a time for the Do-It-Yourself (DIY) approach. You need detailed clauses to protect both the buyer and the seller. They deal with all the what-ifs if any of the risks become reality. Plus, some states require certain disclosures and ongoing reporting.

Wrap MortgageTip #4 – Work with an MLO

Always use professionals to evaluate the transaction, create the paperwork, and close the deal. This includes a Residential Mortgage Loan Originator (RMLO), an experienced real estate attorney, a title insurance company, and a servicing company.

Wrap Note Mistakes That Create Management Problems

Mistake #5 – Trying to Self-Service the Wrap

Imagine the buyer making monthly payments to the seller as agreed. A year goes by, and the buyer discovers that the seller kept the entire payment and never sent the portion to the lender. Now the bank has filed for closure and called the balance due. Whether you call it negligence or fraud, that’s a big problem that could have been avoided.

Wrap Mortgage Tip #5 – Use a Servicing Company

Use a servicing company to collect monthly payments. Be sure they are licensed in the state where the property is located. Have the servicing company disburse the payment to the underlying first lien holder. Set up escrows for taxes and insurance, and have them pass through to the lender if the lender also maintains reserves. Track timely payment of taxes and insurance with annual reporting.

Mistake #6 – Failing to Stay Engaged in the Transaction

We are seeing a new breed of creative “sub-to” financing that could be called “creating a wrap and walking away.” They put the deals together, exit the transaction, and leave the seller and the buyer to figure it all out.

• No ongoing responsibility
• No monitoring
• No review of underlying payments
• No communication
• No oversight
• No protections

They assume everything will take care of itself.

Wrap Mortgage Tip #6 – Stay Honorable

If you are creating wrap notes, have a vested interest in the transaction. Maintain a legal, financial, and ethical obligation to stay involved. Act honorably.

Mistake #7 – Paying the Underlying 1st Lien Late

The easiest way to get a lender’s attention is to stop making payments.

It should seem obvious. Nothing triggers an acceleration or a due-on-sale clause like a missed payment to the first-lien holder. Wraps and non-performing notes don’t mix.

Wrap Mortgage Tip #7 – Stay Current on the First Lien

The first lien should be current and stay current when working with wraps. In addition to using a servicing company, you can consider front-loading payments. This is accomplished by paying the first lien ahead by a payment or two. That way, if the wrap buyer is late, the wrap seller isn’t scrambling to get the payment covered on the first. At a minimum, be sure the due date on the wrap note allows enough time for the payment to get to the first on time.

Mistakes That Create Structural Problems

Mistake #8 – Creating a Deal That Is Too Skinny

We once saw a deal where the first lien was 11% and the wrap note was 9.5%. That’s negative rate spread.

Wrap notes aren’t a solution to skinny deals. If a deal can’t be done profitably through traditional means, a wrap can’t fix that. This comes in many formats:

• Not enough interest-rate spread
• Not enough equity
• Not enough cash flow cushion
• No room for surprises

Wrap Mortgage Tip #8 – The Wrap Interest Rate Needs to be Higher

The interest rate on a wrap note should be higher than the underlying first lien. We suggest a minimum of 2-4%. So, if the first is at 4%, then the wrap should be between 6-8% or higher.

Be sure there is enough equity in the deal that, if necessary, the wrap note could be sold, and the seller could pay off the first lien.

Mistake #9 – Ignoring Special Loan Terms

A real estate investor contacted us in a bind. They had a private money loan with a balloon that had come due. They had negotiated an extension, but that time was fast approaching. They had bought the property, fixed it up nicely, and sold it with owner financing to help a first-time home buyer. They used an RMLO to qualify the buyer and made provisions for taxes and insurance.

The problem? The first lien had a balloon payment, but the wrap note amortized over 30 years. We bought the wrap note and paid off the first from the proceeds. We got the deal done. Unfortunately, the seller had to bring in $15,000 to make the deal work.

Problems arise when notes have special terms that don’t align. These can include:

• Balloon dates
• Adjustable rates
• Prepayment penalties
• Call provisions
• Deed Releases
• Other special terms

Sometimes wrap problems are buried in documents people never read.

These can be hidden in the fine print or, worse, never disclosed.

Wrap Mortgage Tip #9 – Know All the Terms

Read through all documentation on the 1st and the wrap note. Pay attention to terms, maturity dates, and any special provisions. If amortizing, the underlying first should not go longer than the wrap note. If there is a balloon on the underlying first, then the wrap needs to balloon or payoff in full by then. Better yet, try to avoid balloons altogether.

Mistake #10 – Failing to Consider the Full Payment for the Long Term

The payment that works today may not work three years from now.

Imagine you live in Florida, and insurance premiums have gone up. The lender sends a statement that, between taxes and insurance, the payment on the first will now increase by $300 per month. The seller approaches the wrap buyer to increase the payment, but there’s no provision for it.

That’s just one example of a problem that comes from not considering the full payment for the long term. That can include:

• Taxes
• Insurance (including flood insurance)
• Private Mortgage Insurance (PMI)
• Servicing costs
• Rising expenses 

Wrap Mortgage Tip #10 – Consider the Full Picture and Timeline

Consider the full payment due on the first and the wrap. It’s often more than just principal and interest. Make provisions for increases. Do an annual accounting of the wrap and the first lien. Remember to use a third-party licensed servicing company (from Tip #5), and realize that the cost will be higher for a wrap note, as their responsibility and time will be greater.

Wrap Notes are a Great Asset – When Used Correctly

Wraps are tools. Like any financial tool, they can be used effectively or carelessly.

Most of the problems discussed in this article are preventable. They come from poor planning, poor communication, weak documentation, or a lack of ongoing oversight. A properly structured wrap can help a seller create income, help a buyer purchase a property, and create a win-win solution when traditional financing falls short.

If you’re new to wraps, start with our article “What Is a Wrap Note?”

If you’re already involved in a wrap and want to understand how professional note buyers often eliminate wrap risk by paying off the underlying loan, read: “Wraparound Notes: How Note Buyers Eliminate Wrap Risk”

The wrap notes that work best are the ones where everyone understands the risks, communicates clearly, and stays committed to making the transaction successful. Whether you’re creating a wrap, holding a wrap, or considering selling one, we’d be happy to review the transaction and discuss your options.