She offered to "wrap" her loan. I don't understand what I'd sign.

The 20k is the part I'd stare at. She raised the price and raised your balance, and both of those things make her spread bigger. That doesn't make it a bad deal, it just means you're paying for the financing in two places at once, the rate and the price. Run your payment against the bank quote at 245k and see how many months of savings it takes to eat 20k of extra principal. If the answer is longer than you plan to hold, the wrap is costing you money.

Your understanding of the mechanics is right. The bit that gets people is your second question, and yes, it's real. If she pockets your payment and stops paying her underlying loan, her lender forecloses on the house you're living in and paying for. You're current and still exposed. The usual answer is a servicing arrangement, a third party collects from you, pays the underlying loan directly, and forwards her the difference. It costs something like 25 to 50 a month and it removes the single worst failure mode in the whole structure. I would not do one of these without it.

Ask her flat out why she's doing it this way instead of just taking your 20% down and cashing out. If the answer is "I like the income," fine, that's a real reason and a fair trade. If she gets vague, or if there's a lien or a tax issue you'd find in a title search anyway, better to know before the lawyer bills you.

Four answers, then the piece everything hangs on.

The bank does not have to be told in the sense that no one calls them, and most mortgages carry a due-on-sale clause that gives the lender the right to demand payoff when the property transfers. Whether a given transfer triggers it and what the lender does about it depends on the loan documents and on state law, so that clause needs to be read by a real estate attorney in your state before you sign, not summarized by anyone here. The structure does not make the clause disappear. It leaves it sitting there.

Deed and loan: in a standard wrap you take title, the seller's loan stays in her name, and her lender's lien stays senior to your new note. Your note to her is junior to her mortgage. That is the source of your payment risk, and a collection escrow that pays the underlying loan before the seller sees a dollar is the standard mitigation.

On the numbers. She is lending 240k at 6.75% against a 158k obligation at 3.9%. Her spread is roughly 6.75% on the whole 240k minus 3.9% on the 158k, which is about 16,200 minus 6,160, call it 10,000 a year in year one on 82k of actual equity. That is a strong yield for her, and it's why she raised the price. Your side of the trade only works if the payment savings plus whatever appreciation you get exceeds the 20k premium over the seven years.

The balloon is what makes or breaks this. Everything else is arithmetic. If you cannot refinance or sell in year seven at whatever rates exist then, the spread she earns is irrelevant to you. Ask for an extension option in writing and price the deal as though you'll need it.

Nobody's mentioned insurance and it bites people on these. Her lender has her named as insured on a policy for a house she no longer occupies or owns. You need your own coverage, her lender needs to still see coverage it accepts, and the two have to not conflict. I've watched a carrier cancel over an occupancy change and the lender got a notice about it. Sort that with your agent before closing, not after.

I had to read this three times to get it. So the seller is a lender to you, and also still a borrower to her bank, at the same time, on the same house? And the difference between the two is her income. That's genuinely clever and also sounds like a lot of things stacked on each other.

Reading your list again, the thing you'd hold onto is that your payment is lower on her terms. Check whether taxes and insurance are inside that number or outside it. Seller carry notes very often don't escrow, and the payment looks great until you find out you're writing a separate 380 a month check for the county. That flipped the comparison for me on a deal I was looking at last year.