Question: We have found a house that we would like to purchase. Our credit is strong, and our household income is good. However, it is not high enough to qualify for the loan necessary to purchase this house.

The seller is willing to hold paper for the sales price, and we are to pay interest only each month. We have the option to make periodic principal payments, so as to reduce our obligations to the seller. However, they have an existing mortgage on the property. Is there any way we can structure an arrangement which would allow the current owners to retain that mortgage? The sellers believe that under such a procedure, they can make additional money from the monthly payments we will be giving to them.

Answer: The process you are considering is called a "wrap-around" mortgage. At the outset of this column it must be stated that while this is completely legal, you run the risk that the current lender may call the loan because it may violate the "due on sale" clause which is contained in your seller's loan documents.

Let's give an example: You want to purchase the property for $300,000 and there is an existing mortgage in the amount of $200,000. That mortgage carries an interest rate of 5.5 percent, and the monthly mortgage payment is $1135. The seller is prepared to sell the property to you and take back the full amount of $300,000. You will pay the seller interest only on that new loan at 6.5 percent, and that monthly payment will be $1625.

In other words, the seller will remain obligated to pay $1135 to the current lender each and every month, but will be receiving $1625 from you -- for a monthly gain of $490.

Sounds good? Here's how it will be structured. The seller will give you a deed to the property. You will sign a promissory note in the amount of $300,000 in favor of the seller, and agree to pay interest only at 6.5 percent per annum. To protect the seller -- and to assure that you can deduct your interest payments for income tax purposes -- you will also sign a deed of trust, which will be recorded on the land records in the jurisdiction where your property is located.

Keep in mind that this is a second deed of trust. The first deed of trust is in favor of the original lender, whose loan will not be paid off when the deed is recorded into your name. In effect, your second trust is "wrapped" around the existing first trust, and thus the name "wrap-mortgage."

In theory, this is an interesting technique. In fact, during periods when interest rates were very high (such as in the 1970's), many buyers and sellers used the wrap mortgage so that the buyer could take advantage of the lower mortgage interest rate that was contained in the seller's existing mortgage.

However, there is a major catch to this process -- and it is called the "due on sale" clause. Almost all deeds of trust (mortgages) in today's marketplace contain a provision which reads as follows:

Transfer of the Property; Assumption. If all or any part of the Property or an interest therein is sold, transferred (transfer to include but be not limited to any lease containing a purchase option, lease for more than three years, land installment contract or contract for Deed) or further encumbered by Borrower without Lender's prior written consent, Lender may at Lender's option declare all the sums secured by this Deed of Trust immediately due and payable.

The due of sale clause was specifically designed to protect lenders. If they made a loan of three percent to borrower A, and if rates are at seven percent when B wants to buy A's house, B should not be able to assume (step into A's shoes) that low interest rate.

The wrap-around mortgage is legal -- but there is always the risk that the lender will learn about the new transaction and call the original loan. Thus, while this procedure sounds like a "win-win" situation for you and your seller, it could end up as a "lose-lose" situation for both of you.

I am not suggesting that you discard this option, but it should be considered only as a last resort. Are you absolutely sure that you cannot get a new mortgage loan? Have you talked with other mortgage lenders, including the lender who holds the existing first trust on the property? Have you considered getting a smaller loan -- one which you can afford -- and having the seller take back a smaller second trust? That second trust can carry a higher mortgage interest rate, so as to compensate the seller for taking back this paper.

If you ultimately decide to go the wrap route, there are several things which should be included in a written document:

• Who will be paying the first mortgage lender? Regardless of who makes the payment, the other party to the transaction must be provided proof of these payments on a periodic basis. You don't want the situation to occur whereby the seller thinks you are paying that mortgage, and you think that the seller is making the payments -- and no payments are, in fact, made;

• Make sure that the wrap-mortgage (the second trust) is properly recorded among the land records;

• Confirm that there is adequate homeowner insurance, which makes both lenders beneficiaries under the policy in the event that there is damage to the property;

• At the end of each year, you (as buyer-borrower) are entitled to take all of the mortgage interest deductions on your annual income tax return. You must make sure that you have an accurate -- and complete -- accounting. Keep in mind that the existing first trust lender will continue to send notices and tax forms to your seller.

• Your seller is obligated to send you, each year, an IRS Form 1098, reflecting the mortgage interest which you have paid to the seller.

A wrap is a useful tool for buyers and sellers; but you -- and your seller -- must enter into this transaction with your eyes wide open and after you both receive independent legal advice.

Published: May 31, 2004

Use of this article without permission is a violation of federal copyright laws.

Author of the weekly Housing Counsel column with The Washington Post for nearly 30 years, Benny Kass is the senior partner with the Washington, DC law firm of Kass, Mitek & Kass, PLLC and a specialist in such real estate legal areas as commercial and residential financing, closings, foreclosures and workouts. Mr. Kass is a Charter Member of the College of Community Association Attorneys, and has written extensively about community association issues. In addition, he is a life member of the National Conference of Commissioners on Uniform State Laws. In this capacity, he has been involved in the development of almost all of the Commission’s real estate laws, including the Uniform Common Interest Ownership Act which has been adopted in many states.