From Commercial Real Estate Practice Manual With Forms, Second Edition
A wraparound mortgage (also called a Piggyback Mortgage) is a special type of second mortgage. It has all of the characteristics of a second mortgage, including being subordinate to the first mortgage, but also has the following additional characteristics:
- It overstates the principal amount by including, in addition to the amount actually advanced, the unpaid principal amount of the first mortgage; and
- It includes an agreement that the wraparound mortgagee (the lender) will make all required monthly principal and interest payments on the first mortgage (so long as all payments by the mortgagor (the borrower) are current on the wraparound mortgage).1
An example of how a wraparound mortgage works is as follows. Assume that the first mortgage has a balance of $65,000 with interest at 8% per annum on a parcel of real property valued at $120,000. The first mortgage is only for 54% of the value of the property. There is no right to prepay the first mortgage for the next two years, but the borrower presently needs additional funds. A lender could lend up to 75% of value or $90,000 at an 8.5% interest rate. This would mean an additional $25,000 available to the borrower at a rate lower than the second mortgage rate in the market. Because the first mortgage may not be prepaid, the lender could lend the $25,000 under a wraparound mortgage (provided there is no prohibition in the first mortgage against subordinate financing). The note and wraparound mortgage are executed for $90,000 at the interest rate of 8.5% per annum, and the monthly payments would be computed on the $90,000 sum. The lender would then agree to make all of principal and interest payments on the first mortgage as long as the borrower pays all of the payments on the wraparound mortgage when they are due. The lender would have an effective interest rate of 9.8% on the actual amount advanced because the lender is collecting interest on $90,000 but has advanced only $25,000. This occurs because the lender receives 8.5% on the $25,000 advanced, while also making 0.5% on the $65,000 due under the first mortgage. If the constant payment of principal and interest is not sufficient to make the full payment on the first mortgage and the interest on the amount advanced, the shortfall would be added to the principal of the wraparound mortgage. The interest on the shortfall gives an added return to the wraparound lender.
The characteristics of a wraparound mortgage are:
- The face amount of the note and mortgage is the aggregate of the outstanding first mortgage principal and the additional amount advanced.
- There is an agreement between the borrower and the lender that the lender will pay the monthly payment of principal and interest on the first mortgage when they become due provided that the borrower pays the monthly payments on the wraparound mortgage when they become due.
- The wraparound mortgage contains the same tax and insurance escrow language as is contained in the first mortgage.
- The borrower makes the usual mortgage covenants and also covenants to comply with all the provisions of the first mortgage (except for the monthly payments for which the lender will be responsible if the borrower makes timely payments to the lender).
Some advantages of a wraparound mortgage to the borrower are:
- The borrower may be able to obtain a lower interest rate than it could obtain with a true second mortgage.
- The borrower may be able to obtain funds sooner than if it waited until it could prepay the first mortgage.
- If the first mortgage has a low interest rate, the first lender might want to increase the interest rate on the entire indebtedness when agreeing to lend additional funds. The wraparound mortgage lender can provide a lower overall interest rate.
- If the first mortgage can be prepaid only with a substantial prepayment premium, the wraparound mortgage could save the borrower that expense.
- The wraparound mortgage lender has the advantage of a higher effective yield with the least amount of cash investment, thus justifying the lower interest rate than a pure traditional mortgage.
The lender must be certain that the effective yield does not violate the usury laws of the particular state governing the loan. Some states would consider the stated interest rate in the note when determining usury. Other states would consider the effective rate and not the stated rate.2
If the monthly payment is not sufficient to pay the total monthly payment on the first mortgage and the total monthly amount on the additional sums advanced, the lender must examine state laws to determine if interest on interest is permitted. Some states do not permit interest on interest; others permit simple interest on interest; and still others permit the compounding of interest.
The lender must examine the first mortgage documents carefully. If there is a prohibition against subordinate or junior liens, the lender should not accept a wraparound mortgage, as it would constitute a subordinate or junior lien.
The lender must be certain that any default on the first mortgage is also deemed a default under the wraparound mortgage. Otherwise, the wraparound lender might not be permitted to call the entire loan due and payable in the event the first mortgage is declared due and payable.
The lender must be certain that it has the authority to make a wraparound mortgage. If the lender is only authorized by state law to make first mortgages, it may not make a wraparound mortgage investment. If the state has a “basket clause” in the statute,3 permitting the lender to make investments up to a certain limit that appear sound but are not permitted under any other statute, then the lender can make the loan under the basket clause, provided the lender has not made prior investments up to the limit permitted under the clause.
Attention must be given to the fact that the lender might be required under certain circumstances to make additional advances to the initial disbursement. This is especially a concern if the monthly payment on the wrap-around mortgage is less than the total monthly payment due on the first mortgage. In such case, the wraparound mortgage lender will need to ascertain whether the title insurer will insure the priority of the lien of the wraparound mortgage over liens recorded after the initial advance but prior to the future advances.
If a state has a mortgage tax, the state may require payment of the tax on the entire principal amount, instead of only on the amount advanced under the wraparound mortgage.
A second mortgage is a mortgage subordinate or junior to the first mortgage on real property. The basic form is often the same as the first mortgage, with the addition of a few provisions for the protection of the second mortgagee (the second lender). Among the additional provisions typically contained in a second mortgage are:
- A provision restricting subordination of the first mortgage as to the principal amount and the conditions it contains at the time of the execution of the second mortgage. It should prohibit any modification, extension, increase, or replacement of the first mortgage without the second lender’s approval.
- A provision prohibiting any change in the monthly payments of the first mortgage. If the monthly payments are increased, it can benefit the second lender in that the first mortgage would be paid faster, thereby increasing the equity for the second lender. It can also be damaging to the second lender to the extent that the first lender takes most of the cash flow, leaving an insufficient amount remaining to apply to the payments due on the second mortgage debt. If the first mortgage payments are reduced, there is more money available for the second mortgage payments, but the principal amount of the first mortgage is not reducing as fast.
- A requirement for the borrower to escrow the first mortgage payments with the second lender. This assures the second lender that the first mortgage payments will be made when due on the first mortgage, thereby avoiding the foreclosure of the first mortgage for nonpayment.
- A right to require notice of defaults under the first mortgage and an opportunity to cure them. The first lender always resists the obligation to give notice, because failure to give notice can be a defense in a foreclosure action. The first lender might agree to give notice without being obligated to do so. The second lender wants the right to cure any default under the first mortgage so as to avoid a foreclosure of the first mortgage.
- An encumbrance on additional security or some other protection, such as a guaranty. Because the second mortgage is in a subordinate position, the second lender often requires additional security, such as a lien on additional land, a pledge of stock, and/or a guaranty of payment. The second lender will always require personal liability on the part of the borrower.
- Provisions with respect to the first mortgage. The second lender will want affirmative covenants that: (1) the second mortgage is executed in conformity with the first mortgage; (2) the borrower will comply promptly with all obligations contained in the first mortgage; (3) the borrower will notify the second lender immediately of any defaults under the first mortgage; (4) the borrower will not enter into any agreement with the first lender to waive, postpone, extend, reduce or modify the payments due on the first mortgage; (5) the borrower will use its best efforts to obtain an estoppel certificate from the first lender as to compliance with its terms when requested by the second lender; and (6) the borrower will execute any certificate required to authorize the second lender to cure any defaults under the first mortgage.
- A provision that a default under the first mortgage is also deemed a default under the second mortgage.
Requirements of First Mortgagee
A review of the requirements of a first lender are as follows:
- The second lender must agree that if the first lender releases any insurance proceeds or partial condemnation awards for restoration, the second lender must also agree to release such amounts for restoration;
- If the first lender subordinates its mortgage to any lease, the second lender must agree to subordinate the second mortgage to the lease; and
- The second lender may not acquire any lien superior to the first mortgage, by subrogation or otherwise, unless, within some fixed period of time after written notice thereof to the first lender, the first lender fails or refuses to purchase or acquire the prior lien or interest, or fails to commence any action and thereafter proceed with due diligence to purchase or acquire the prior lien.
The first lender will limit the total financing, that is, the aggregate amount of the first and second mortgages, to a certain percentage of the appraised value, and will limit the aggregate monthly payments to a certain percentage of net cash flow from the real property. Some first lenders: (i) refuse to give any notice of defaults to a second lender; (ii) reserve the right to enter into any modifications, extensions, advance agreements, or deferrals of payments with out the approval of the second lender; and (iii) require certain specific language to be contained in the second mortgage.
First lenders do not like to have second mortgages placed upon the real property encumbered by the first mortgage. It can be argued that the first lender is not harmed in any way by the second mortgage, and in the event of foreclosure, the second lender cannot receive any payments until the first mortgage is paid in full. Many times, however, a second lender will see that all payments are made on the first mortgage and then take the excess cash flow in reduction of the second mortgage. The second lender will not pay taxes, make necessary repairs, or even maintain the required insurance. After the second lender recoups all of its funds, it will let the first mortgage go into default. The first lender then might find it is required to pay all the taxes, do the repair work, and obtain insurance in order to protect its security. For this reason, the first mortgage contains a prohibition against subordinate or junior liens of any type. Some first lenders that demand the prohibition against subordinate financing will consent to a second mortgage upon receipt of all the facts and the name of the second lender. The first lender will want to know the terms of the second mortgage to be certain that the cash flow is not being invaded to the extent that there are no funds left for maintenance of the real property. The first lender may require the establishment of a tax and insurance escrow account.
Another form of second mortgage financing is called a “gap mortgage.” This occurs when there is a construction loan with a permanent take-out commitment. The permanent take-out commitment must provide for a certain disbursement upon completion of construction (floor amount), with additional amounts disbursed as certain rental income levels are achieved. Many times, more money than the floor amount is needed for completion of construction. In such cases, the construction lender agrees to take the position of second lender under a gap mortgage for the additional amounts. The permanent first lender will consent to the second mortgage, notwithstanding that subordinate financing is prohibited in the first mortgage. The permanent first lender, the construction lender, and the borrower would agree that when the rental income achievement is attained, the permanent first lender would disburse the additional funds directly to the construction lender to reduce the gap mortgage. After the permanent first lender has disbursed all the proceeds of the permanent loan, the gap mortgage will be paid in full.
The gap mortgage usually has a maturity date that is the same date the permanent first lender is required to make the final disbursement under the permanent loan commitment. If the rental achievement is not met, the borrower would still be required to pay the gap mortgage in full.
Because of some practices that have developed in the second mortgage market, some states have enacted laws4 requiring second mortgage lenders, mainly secured by mortgages of one- to four-family dwellings or those lending $15,000 or less for a year secured by a second mortgage, to register with the state and to obtain a license. Each year, in addition to making annual reports, the second mortgage lender must also renew its license. The statutes usually do not apply to second mortgage lenders with respect to commercial properties, but the state law should be checked in each case.
1. See Gunning, The Wraparound Mortgage . . . Friend or U.F.O.?, Real Est. Rev.
35–48 (Summer 1972).
2. Skinner v. Cen-Pen Corp., 414 S.E.2d 824 (Va. 1992).
3. N.Y. Ins. Law § 81(17) changed to New York Consolidated Laws (Insurance), Art. 14,
4. See Ohio Rev. Code § 1321.51 et seq.; N.J. Stat. Ann.§ 11A-1 et seq.