When buying a home, it’s relatively common to encounter loan contingencies. A loan contingency is a clause in a real estate contract that the buyer must meet before the sale of a home is approved. Keep in mind we’re not lawyers so this isn’t legal advice, but loan contingencies are common in the mortgage industry so we want to walk you through the basics.
What is a loan contingency and how does it work?
Loan contingencies are designed to protect both the seller and the buyer in a mortgage transaction.
- How it protects the seller: If the buyer can’t get a home loan within a stated time frame, then the contract is voided. This protects the seller because it allows them to back out of the home purchase agreement and make a deal with a different buyer.
- How it protects the buyer: If a buyer can’t get final approval on the loan by the stated deadline, they can back out of the purchase and still get their earnest money deposit back.
What is an earnest money deposit? Your earnest money deposit is the money you put down to show you’re serious about the purchase, and it is one of the upfront costs you’ll pay when buying a home. The earnest money deposit is typically 1% to 3% of the home’s purchase price.
If the sale goes through, the earnest money is applied to the down payment, and if it doesn’t go through, you give up the earnest money assuming there aren’t contingencies.
Additionally, there are loan contingencies that spell out the type of interest rate and fees the buyer should receive for the deal to close. This allows the buyer to back out of the purchase without penalty if fees and current mortgage rates rise above the amount set in the contingency.
Financial loan contingencies
When buying a house, there can also be other financial loan contingencies attached to the deal. Some of the contingencies you might see include:
- Home inspection: The agreement might be contingent on a home inspection. If there are major issues with the home that weren’t disclosed by the seller, a buyer can usually back out of the purchase without penalty before the home closing date.
- Appraisal: Adding an appraisal contingency can protect the buyer by ensuring that the home appraises for at least the purchase price. If the home appraises for less than the purchase price, having this contingency in the paperwork allows you to back out of the purchase without losing earnest money or increasing your down payment.
- Home sale: With a home sale contingency, the buyer needs to sell their current residence for the sale of the new home to go through. This reduces the chance that a buyer will be stuck with two mortgage payments if their current home doesn’t sell. It might also allow for a longer timeline to buy the home.
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Active vs. passive contingencies
When reviewing loan contingencies, it’s important to understand the difference between active and passive clauses:
- Active contingency: Active contingency removal requires you to actually release the contingency. For example, if you have a home inspection contingency set for 20 days, but you don’t actively remove the contingency, it remains in force. You can still get the home inspection, or await the results if they have been delayed, and not risk losing the earnest money you’ve set aside.
- Passive contingency: On the other hand, with passive contingency removal, the contingency is automatically removed once the deadline passes. For a mortgage contingency clause that requires you to let the seller know whether you have financing within 30 days, you must let them know, or the contingency expires. If you don’t have financing after the contingency is removed, and you haven’t canceled the contract, you can’t be forced to buy the home, but you could lose your earnest money.
Active loan contingency removal protects buyers who make an offer on a home, since it keeps the contingency in the contract, even after deadlines have passed. However, they also require more paperwork. Pay attention to the type of loan contingencies involved before signing the contract.
Contingencies in a buyer’s market vs. a seller’s market
Mortgage contingency clauses can impact you in different ways depending on whether it’s a buyer’s or seller’s market. Here’s what you need to know about loan contingencies, depending on the time you buy.
Buyer’s market
In a buyer’s market, a loan contingency can provide protection when you’re making a purchase. A seller who wants the deal to go through might allow for various contingencies in the interest of putting the buyer at ease.
These contingencies give you more wiggle room to back out of the contract without penalty if a better deal comes up, or if there are problems with the home. Plus, you might also have the upper hand when negotiating closing costs.
Seller’s market
In a seller’s market, there’s a little less power for the buyer. Because loan contingencies require agreement on the time frame for each, a seller can request a shorter time frame. A buyer then needs to fulfill the terms quickly or be released from the contract, freeing up the seller to accept a better offer.
The seller might also find your offer less appealing if it has several contingencies and opt for another offer with fewer or no contingencies in place.
Check out: Contingent Offer: Should You Use One to Buy a House?
Can a loan contingency be extended?
If it turns out you can’t meet the requirements of a loan contingency within the stated time frame, you can ask for an extension. However, this usually requires help from a lawyer as well as additional paperwork.
In some cases, you might need to add more earnest money to the escrow account. All of this can increase your closing costs in some cases.
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What about waiving a loan contingency?
Waiving a loan contingency might help move towards closing faster, especially in the case of a home inspection or home appraisal contingency. However, when you waive your contingency, you also lose the ability to back out of the contract without penalty if an issue arises.
For example
If the home appraises for less than the purchase price, your lender might not increase what it gives you. It’s up to you to come up with the difference. If you then need to back out, but have waived your contingency, you’ll lose your earnest money.
Loan contingency removal can help a buyer in a seller’s market, though. Removing a contingency can allow you to move up the closing and show the seller that you’re serious about purchasing. Whenever you remove a contingency, though, you run the risk of other problems. In some states, if you don’t have a contingency and you back out of a home sale, the seller can sue for breach of contract.
Carefully consider the options before moving forward. Weigh the pros and cons, as well as your financial situation, and consider consulting with your real estate agent before you decide to waive a loan contingency.
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