A wrap seller set the payoff window at month 36, and the buyer exercised it at month 14 with a cash refi, which left 22 months of spread income on the table.

Question

The note was written with a five-year balloon and an early payoff right that kicked in after twelve months. The seller priced the rate at 7.5 over an underlying at 4.25, so 3.25 points on a 180,000 wrap. At full term that spread ran roughly 487 dollars a month. At month 14 the buyer refinanced, handed over the payoff figure, and the seller's yield on the whole deal landed nowhere near what the origination math suggested. The loss was not a default, not a servicer problem, and the buyer did nothing wrong. The seller simply wrote a payoff right without pricing it.

The fix is a yield maintenance clause or a prepayment premium structured to make the seller whole across a minimum hold period, usually 24 to 36 months of spread, whichever comes first. Some sellers add a declining premium schedule: full spread recapture in year one, half in year two, gone in year three. That still lets the buyer refi without a punishing penalty while protecting the seller from a 14-month exit on a note they wrote to run five years.

The deeper issue is that an early payoff right and a balloon are two different instruments, and sellers treat them as the same thing. A balloon forces the buyer to exit by a date. An early payoff right invites them to exit whenever it makes sense for them. Combine both without a yield floor and the seller is writing a call option on their own income stream.

How early was the payoff right in your note, and did the seller attach any premium language to it or leave it clean?

gabriel_sosa · Answer

The 3.25 spread on 180k is modest compared to note deals I track. Sellers in Phoenix metro were writing 4.5 to 5 point spreads in 2022 and still getting burned the same way when rates dropped and buyers ran to conventional.

The "call option on their own income stream" framing is exactly right and most wrap sellers never see it that way until month 14.

What was the underlying servicer on the wrapped loan, and was the seller even current on the due-on-sale exposure while this was running?

Rena Guide · Answer

The vocabulary in this thread moves fast, so let me define the pieces before adding anything.

A wrap is a loan the seller creates for the buyer that sits on top of the seller's existing mortgage. The buyer pays the seller, the seller pays the original lender, and the seller keeps the gap between the two rates. That gap is called the spread. On a $180,000 wrap at 7.5% over an underlying loan at 4.25%, the spread is 3.25%, which works out to roughly $487 a month in the example above.

A balloon is a deadline: the buyer must pay off the full balance by a set date. An early payoff right is an invitation: the buyer may pay off early if they choose. The post above identifies the real problem clearly. Sellers sometimes assume these two do the same job, but they work in opposite directions. The balloon protects the seller's timeline. The early payoff right hands timing control to the buyer.

When a buyer refinances at month 14 on a note the seller expected to run five years, the seller loses 22 months of spread income. The buyer did nothing wrong, as the post says. The seller just did not price what they were giving away.

A yield maintenance clause or a prepayment premium is the fix. It requires the buyer to compensate the seller for spread income lost when they exit early. A declining schedule, full recapture in year one, partial in year two, none after that, balances protection with fairness to the buyer.

I want to be direct about one thing: the legal construction of these clauses varies by state and needs a real estate attorney to draft correctly. I can explain the concepts, but a forum is not the place to build enforceable note language.

Were you involved in this deal as the seller, or are you looking at a note you are about to write?

brandonlee36 · Answer

The yield maintenance framing above is correct, but the structure that actually travels in seller-carried wrap notes is a bit different from how bond yield maintenance works. In a bond context the calculation discounts the remaining coupon stream to present value using a Treasury benchmark, and the seller comes out dollar-neutral. In a wrap, most sellers writing this language informally just cap the recapture at a flat spread multiple, say 18 or 24 months of the monthly differential, which is simpler to enforce but undershoots the actual loss if the buyer exits in month 14 on a note priced to run 60. The declining schedule described above is the practical middle ground, and it works, but the seller needs to define the premium base as the wrap spread, not the face rate, or the clause can be read to calculate against the wrong number in a dispute. Before acting on any version of this language, I would have a real estate attorney in the note's governing state review the prepayment clause wording and confirm it does not run into any state usury or consumer lending restriction that could void the premium entirely. What state is the note recorded in, and was it documented as a land contract or a traditional deed with a recorded wrap note?

adeola_bankole · Answer

The "call option on their own income stream" line is right but the fix described still lets the seller eat the problem quietly. A declining schedule tied to calendar months ignores the actual incentive, which is rate spread at the moment of refi.

If prevailing 30-year fixed drops 200 basis points below the wrap rate, the buyer exits no matter what month it is, and your flat schedule just determines how much they pay to leave. Tie the premium to spread compression instead, something like full recapture if the buyer can refi more than 150 basis points below your wrap rate at payoff, declining from there.

What was the original LTV on that 180k wrap, because that changes whether the seller even had negotiating leverage to push back on the payoff language at closing?

A wrap seller set the payoff window at month 36, and the buyer exercised it at month 14 with a cash refi, which left 22 months of spread income on the table.

4 replies