Wraparound Mortgage or Lease Option in Texas Real Estate?
The wraparound mortgage and the lease option are two creative ways to sell residential real estate in Texas. They both offer an alternative to buyers and sellers who are unwilling or unable to use conventional lending to close the purchase and sale of the property. Unfortunately, both methods are also subject to strict governmental regulations and harsh penalties for violations. This article explores the risks and benefits of each creative financing technique.
A wraparound mortgage involves the transfer of title to real property (the deed) without paying off the underlying mortgage financing (the deed of trust). Let’s say Sam Seller owns a house worth $200,000 and he owes $100,000 on his mortgage to Bob’s Bank. Pete Purchaser wants to buy Sam’s house, but maybe he can’t qualify for a new bank loan. Or maybe he hates banks because a guy named Chase Manhattan stole his girlfriend one time. In any event, a conventional loan isn’t going to work, so instead, Sam and Pete agree on a wraparound mortgage. Pete pays Sam a $20,000 down payment in cash and Sam deeds the house to Pete, but Sam carries back a new $180,000 mortgage on the house. Sam doesn’t pay off his loan from Bob’s Bank; instead, every month Pete pays Sam the payment on the $180,000 note, and Sam keeps paying Bob’s Bank on the $100,000 loan. The new $180,000 loan has “wrapped around” the old $100,000 loan.
“Wait, isn’t this illegal?” someone yells from the cheap seats. No, it is perfectly legal. Now, most conventional mortgages contain a “due on sale” clause, which give the lender the option to call the note due if the underlying property is sold. However, Bob’s Bank, like all banks, is in the business of making loans and not owning real estate, and therefore, Bob’s Bank has no intention of calling Sam’s note due so long as Sam keeps paying Sam’s note. That is why the wraparound mortgage works as a benefit to Sam, Pete, and Bob.
Wraparound mortgages are a form of seller financing, and therefore they are subject to both the federal and state versions of the Secure and Fair Enforcement for Mortgage Licensing Act of 2009 (the “SAFE Act”) and the Mortgage Reform and Anti-Predatory Lending Act (commonly known as “Dodd-Frank”).
The SAFE Act requires a seller of real estate to be a licensed loan originator if the seller’s property is not a homestead or the buyer is not a family member of the seller. There is a de minimis exception for sellers who make five or fewer seller-financed transactions in one year, so this law mainly affects active real estate investors and not residential homeowners.
Dodd-Frank is a byzantine, hugely complex law that President Trump has promised to repeal. The Consumer Financial Protection Bureau is the agency charged with implementing Dodd-Frank, which has as its main goals curbing predatory lending practices and avoiding financial meltdowns like the Great Recession of 2008. One key provision of Dodd-Frank requires that the seller in a residential owner-financed transaction determine whether the buyer/borrower has the ability to repay the loan, much like a traditional lender. Other clauses severely restrict the use of balloon payments and other nonstandard loan provisions. These regulations obviously add extra layers of cost and complexity to what would be a simple seller-financed transaction like a wraparound mortgage. Again, there is a de minimis exception to this regulation; a person who seller finances three or fewer properties in any 12-month period is exempt from the requirements as a loan originator.
A wraparound mortgage is also subject to Section 5.016 of the Texas Property Code, which, with some exceptions, requires a disclosure by the seller to the buyer that the property is encumbered by a lien that will not be released when the buyer becomes the owner.
A lease option is another creative financing technique that combines a traditional residential lease with an option for the buyer to purchase the property for a certain price during a certain time period. Unlike a wraparound mortgage, when Sam Seller and Pete Purchaser enter into a lease option agreement, Sam does not convey the property by deed to Pete immediately; instead, Sam will only deed the property to Pete if and when Pete “exercises” the option and pays the full purchase price. Sam continues to pay Bob’s Bank but Sam is still the owner of the property and acts as Pete’s landlord.
Because a lease option is an agreement that contemplates a title transfer in the future and not immediately, it is an “executory contract” and is subject to the Texas Property Code Chapter 5 Subchapter D. Subchapter D, as it was amended in 2005, imposes strict regulations on lease options and harsh punishments for violations of those rules (harsh, as in possible deceptive trade practices violations, possible disgorgement of payments received, treble damages, attorney’s fees, cats and dogs living together, mass hysteria). Some of Subchapter D does not apply to lease options and some of Subchapter D does not apply to executory contracts that are three calendar years or less. Nevertheless, the restrictions and penalties are so tough that after 2005, many Texas real estate investors abandoned lease options entirely, and many Texas real estate lawyers, including me, strongly advised their clients to avoid them.
(Not to mention that lease options might be considered seller financing and if they are, then the SAFE Act and Dodd-Frank would apply to them, too. Yikes!)
If a seller is either selling a homestead or is a small-time investor doing three deals or fewer per year, I would still recommend the wraparound mortgage. Conveying the property at the start of the transaction is cleaner and Texas still has the smoothest and easiest foreclosure process in the nation. But active real estate investors should consider the lease option, especially if it is less than three years and the paperwork is drawn up by a good real estate attorney. Either way, caveat venditor (let the seller beware).