What is a Loan Contingency?
Putting an offer on a house can be heart-wrenching. Although you may love the property, many things can happen during the homebuying process that could make you regret your decision. Therefore, it is not uncommon for prospective buyers to include contingencies with their offer that allow them to back out of the contract without losing their earnest money if some conditions are not met.
Typical contingencies include a satisfactory home inspection contingencies (buyers are allowed to cancel the contract if significant issues are detected), appraisal contingencies (the house must appraise at or above the contract price for the sale to go through), the purchase or sale of another property, such as the would-be buyers’ previous home or the sellers finding suitable living arrangements, and loan contingencies.
Here is everything you need to know about a loan contingency and why it may be a good idea to include them in a home purchase agreement.
What Does Loan Contingency Mean?
Loan contingencies (also known as mortgage contingencies or financing contingencies) are clauses included in home sale agreements that protect the buyer from losing their earnest money if their home loan is not approved in time.
When house hunters start the homebuying process, they typically get pre-approved for a mortgage. However, the final loan approval may take 60 to 90 days as the underwriter verifies the borrowers’ information and details about the property. This delay leaves the risk for unexpected issues to come up during the underwriting process, such as the mortgage being denied if the would-be borrower loses their job, their credit score lowering after a major purchase, interest rates increasing, and so on.
When negotiating the purchase price and sale agreement, the would-be buyer and seller agree on an official date for the mortgage approval to go through as part of the loan contingencies, typically within a week of the projected closing date. Buyers and sellers may opt to include a mortgage contingency clause extension date in the purchase agreement if any issues arise, such as delays due to banking holidays or if the buyers must find a new lender. However, the seller may also choose to cancel the sale and start showing the property to new interested buyers if conditions are not met. Loan contingencies protect the seller from letting the property sit under contract indefinitely as potential buyers wait for their final mortgage approval.
How Does a Loan Contingency Protect Buyers?
Loan contingencies protect the sellers but also the buyers. When making an offer, the buyers typically put in an earnest money deposit payable to a title, escrow company, or brokerage as proof of good faith. This amount, generally equivalent to 1% to 5% of the sales price, is credited to the buyer as part of the down payment at closing. However, the buyer is also at risk of losing it if they back out of the contract.
Loan contingencies protect the buyers if they cannot secure financing since the earnest money is refunded if the sellers cancel the contract. However, they could still lose the earnest money if they chose to back out of the contract after securing a home loan.
What Is the Difference Between an Active and Passive Contingency?
Once the purchase contracts are in place, the loan contingencies can be removed. Loan contingency removal can either be active or passive.
Passive loan contingency removals occur when the contingency periods expire without a house loan being approved and the parties have not canceled the contract. In that case, the would-be buyers may lose their earnest money deposit if they fail to notify the seller.
Active loan contingency removals occur when the parties initiate the removal and notify the others in writing – for example, if their loan application has been approved. They may also request an extension and submit an amendment to the contract in writing if issues arise during the underwriting process. However, the seller is under no obligation to accept the extension and, in some cases, they may request additional earnest money.
Is It a Good Idea to Waive Your Loan Contingency?
As the real estate market heated up, some would-be buyers decided to make their offer more attractive to sellers by waiving their loan contingency.
Waiving a loan contingency allow potential buyers to come toes-to-toes with cash buyers who are not subject to the uncertainties that come with waiting for loan approval. Financing can cause delays, or the sale may fall through at the last minute if the underwriter denies the loan application. However, the sellers are required to pull their property off the market once they accept the buyers’ offer. Therefore, they could be missing other opportunities in the meantime if the sale ends up getting canceled. Waiving loan contingencies can help house hunters sway sellers in their favor during a bidding war without necessarily offering more money.
However, waiving a financial contingency comes at no small risk to the buyers. If the lender denies their mortgage application, they could be at risk of losing their earnest money deposit, which may affect their chances of purchasing another house since their cash reserves would be depleted. If the underwriter approves the mortgage but for a smaller amount than initially planned – if the appraisal comes in low, for example – the would-be buyers may opt to compensate the difference in cash instead.
Therefore, although waiving your loan contingency may be a winning strategy, it also includes major risks and could affect your chances of purchasing another property. It is not a decision to take lightly, and it is best to discuss your options with your real estate agent as well as your mortgage agent to evaluate the risk.
How Long Does It Last?
Loan contingencies typically last between 30 and 60 days, as agreed by both parties. If the borrowers foresee some issues with their financing approval being received on time, they may reach out to the sellers to negotiate a mortgage contingency extension to stretch the mortgage contingency period if the buyers are unable to obtain a loan before the deadline. However, the sellers may choose to deny the request and walk away from the sale after the contingency expires.
What Is Contingency Removal?
The contingency removal date is the date agreed upon by the buyer and seller, specifying when the would-be buyer removes the contingency and commits to purchasing the property. If the potential buyer backs out of the sale at this time, they may lose their earnest deposit and the sellers may sue them for damages in more extreme cases.