The Wrap-Around Mortgage Scam

February 18, 2003 "A local firm has offered to refinance our existing 6.75% mortgage, which has a balance of $100,000. On our behalf, they will arrange for another lender to provide us with a cash-out refinance of $150,000 at 4.875% for 15-years. Three days after settlement, we take a wrap-around mortgage with them for $100,000 at 3.875% and15 years, and they assume responsibility for the $150,000 mortgage. They get to invest the $50,000 difference and we get a loan at a rate 1% below the market. Is this a good deal or a scam.?" It is a scam, but a nicely disguised one. Suppose I said to you, "Lend me $50,000. I�m going to Las Vegas and gamble it. If I win, I�ll give you a small share of my winnings. If I lose, I�ll be gone where you will never find me." You wouldn�t agree to that. No one in their right mind would. Yet that is exactly the deal you are being offered here. Why is this firm willing to pay off a $150,000 loan at 4.875% when you are only paying the firm 3.875% on $100,000? Obviously, because they get your $50,000 to invest. But to make this pay, the scamster must earn a very high return on the $50,000. Simple arithmetic indicates that they must earn 6.875% just to break even, and they are not in business to break even. Probably the scamster intends to invest the $50,000 in junk bonds paying 12-18% or more. If the junk bonds pay off, the scamster will pay off your loan as they promise. And you will get the below-market rate they promise. But suppose the junk bonds they buy go into default, as bonds promising such high yields often do? The scamster will stop paying on your mortgage and disappear. You will, of course, stop paying the scamster, but you will now have to assume responsibility for the original loan of $150,000. Indeed, you were always responsible for this loan. The scamster made a deal with you to assume responsibility, but the other lender was not a party to this deal. Your name is the one on the note and the lender looks to you for payment. Only now you have $150,000 to repay instead of $100,000. If you want to gamble, take the cash-out refi of $150,000 and invest the $50,000 in junk bonds yourself. If the bonds tank, you will lose the $50,000, just as you would if the scamster had bought them. But if the bonds pay off, you get to keep all the gains yourself. That might not be prudent, but at least it is a gamble on which you have a chance to win. Giving your money to someone else to gamble, where they keep most of the winnings but you bear all the losses, is worse than imprudent -- it is stupid. Copyright Jack Guttentag 2003

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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