WRAP Mortgages

Note on WRAPAROUND Mortgage Economics Cyril A. Fox University of Pitsburgh School of Law

The example used in class was of a property subject to a first mortgage with a current principal balance of $1,000,000 and an interest rate of 10%. The owner (of the equity of redemption) wants to borrow another $500,000. This additional loan would be junior to the 1st mortgage. In order to gain some control over the risk of the borrower's defaulting on the 1st mortgage, the lender agrees to lend the funds and take as security a particular type of junior mortgage known as a wraparound mortgage (WRAP mortgage.) The face amount of the note and mortgage given by the borrower-owner (of the equity of redemption) is $1,500,000, the sum of the current principal balance due on the 1st mortgage and the $500,000 in "new funds" being advanced by the lender. The interest rate in the WRAP note and mortgage is 13%, somewhere between the (lower) interest rate on the 1st mortgage and the (higher) interest rate the Lender would charge for a conventional 2nd mortgage.

The borrower-owner makes debt service payments to the lender in the amount necessary to amortize the WRAP note amount of $1,500,000 over a term usually longer than the remaining term of the 1st mortgage.

Under this arrangement, in the first year the lender earns 13% on the $500,000 of its loan and 3% on the $1,000,000 of the 1st mortgage. However, the lender must use the debt service payment it receives to make the payment of the 1st mortgage before applying any funds to its own account. Becase of this, the lender will not actually have all of the money it theoretically earned on the WRAP loan in that year. The following example illustrates what happens.

WRAP Mortgage     WRAP           WRAP          WRAP
Ballance        Payment        Interest      Principal 

1,500,000.00   228,540.00     195,000.00     33,540.00
1,446,460.00   228,540.00     190,640.00     37,900.00
1,428,560.00   228,540.00     185,712.00     42,828.00


1st Mortgage    1st Mortgage  1st Mortgage   1st Mortgage
Ballance         Payment        Interest       Principal 

1,000,000.00   144,000.00     100,000.00     44,000.00
956,000.00     144,000.00      95,600.00     48,400.00
907,600.00     144,000.00      90,760.00     53,240.00

1st year: WRAP payment $228,540.00 less 1st M payout 144,000.00 Cash Balance available $84,540.00 Interest under WRAP Mortgage: $500,000 @ 13% $65,000.00 $1,000,000 @ 3% (13%-10%) 30,000.00 95,000.00 less cash balance available 84,540.00 Interest credited but not received $10,460.00 (cash flow shortage) Principal credited to WRAP Mortgage $33,540.00 Principal credited to 1st Mortgage 44,000.00 Cash Difference = ($10,460.00)

Therefore, as long as the amount of principal credited to the 1st mortgage exceeds the amount of principal credited to the WRAP mortgage, there will be a cash flow shortfall to the WRAP lender and the amount which it has "at risk" under the WRAP will increase. If the term of the WRAP mortgage exceeds the term of the 1st Mortgage, there will come a time when the amount of principal credited to the 1st Mortgage will be less than the amount credited to the WRAP mortgage and the WRAP lender will begin to recoup the shortfall.

A lender engaging in wrap financing, where wrap financing debt carries a highrt interest rate than the underlying (first or prior) debt, receives a higher effective rate of interest higher than the wrap mortgage contract rate. However, the wrap lender does not necessarily receive the cash represented by that higher interest rate in the same year as it is credited to the wrap mortgage, The wrap lender's ability to realize the higher rate will depend on the buyer's ability to make wrap mortgage debt service payments over the full term of the wrap mortgage.

The following charts show how the payments eventually work to the WRAP lender's favor: