Understanding Loan Contingencies in Real Estate Transactions

Buying a home is one of the biggest financial transactions you’ll make in life. So it makes sense you want to protect yourself financially if you can’t follow through with the deal.

That’s where a loan contingency clause comes in handy. It lets you walk away from a real estate deal if you can’t get a mortgage approval. Here’s how a mortgage contingency works and tips on how to make this clause work for you.

What is a loan contingency?

When you buy a home, a loan contingency gives you a contractual exit from the transaction if your lender doesn’t approve you for a mortgage. This clause in a real estate contract allows buyers to back out of the deal without any penalties or legal consequences if they meet the conditions.

Types of real estate contingencies

Here’s a look at the most common types of home purchase contingencies.

Mortgage financing contingency: Even if you’re pre-approved for a mortgage, you could still be denied before closing for a variety of reasons, such as taking out a loan, making a large, unsourced deposit, paying bills late, or losing/changing a job. This clause protects your earnest money and gives you an exit from a real estate transaction without penalties if your financing falls through.

Home appraisal contingency: A home appraisal provides a professional opinion of the property’s current market value. If the purchase price is more than the home’s appraised value, the lender might not approve the loan (or it might only approve up to the appraisal amount). If the buyer can’t make up the difference, the home appraisal clause gives them an out from the contract.

Homeowners insurance contingency: When you finance a home with a mortgage, you must get homeowners insurance. This coverage protects your property against loss or damage from natural disasters, fires, vandalism, and other unforeseen acts. However, if you can’t get insurance or the premiums are too expensive (especially in coastal areas or those prone to wildfires), you won’t be approved for a mortgage either.

Home inspection contingency: A home inspection isn’t required to buy a home, but it’s recommended. This professional evaluation of a home’s condition gives buyers peace of mind and a clear idea of what issues might exist. If the inspection reveals multiple issues, you can negotiate for repairs or credits; if you can’t reach an agreement, an inspection contingency lets you walk away from the deal without penalty.

Home sale contingency: With this clause, you’re able to back out of a home purchase if your existing home doesn’t sell in time. Some buyers include this if they need the equity profit from their home sale to purchase their next home.

Title search contingency: This clause protects you if the property has any outstanding ownership disputes or legal liens or judgments in place. Without a clear title, legal ownership can’t transfer from the seller to the buyer. 

How does a loan contingency work?

A loan contingency, also called a mortgage contingency, is an optional clause within a real estate purchase agreement specifying a deadline for a buyer to secure financing. If you’re denied a home loan or don’t meet your mortgage qualifications, a loan contingency clause allows you to walk away from the deal without financial or legal penalties, and you’ll get your earnest money back.

“If the buyer can’t meet the conditions of the contingency, they can either negotiate for an extension, cancel the contract, or move forward without the financing contingency at their own risk,” says Reilly James Renwick, chief marketing officer at Pragmatic Mortgage Lending. “This is how both sides are protected and still keeps the timeline of the transaction moving.”

With higher interest rates and more stringent loan requirements today, a loan contingency can protect homebuyers’ money. Earnest money deposits are typically 1% to 3% of the home’s asking price. If you’re denied a home loan but don’t have a loan contingency in place, you could potentially lose thousands of dollars in earnest money — and the home you love.

Importance of loan contingencies for buyers and sellers

In a competitive market with bidding wars, some homebuyers might feel pressure to act fast and skip contingencies to stand out to sellers. But if you’re relying on a mortgage to fund your home purchase, waiving a loan contingency is a risky gamble, says Bruce Ailion, an attorney and REALTOR® with RE/MAX Town & Country in Alpharetta, Georgia.

“We have come out of a strong sellers' market cycle where buyers frequently waived contingencies to improve their offer,” Ailion says. “As a REALTOR®, I highly discourage waiving contingencies. Without contingencies, buyers might be afraid to make an offer or have buyer’s remorse later.”

Homebuyers get the following benefits of having a loan contingency:

• Protection of their earnest money deposit
• Time to get approved for the best mortgage
• Flexibility to walk away from the deal if mortgage rates jump significantly
• Protection against appraisal issues that prevent them from qualifying for financing
• Option to negotiate terms if lending conditions change

A loan contingency gives sellers some advantages, too, including:

• A set timeline for the buyer to secure financing
• Protection against long escrow periods
• Ability to continue marketing their home and accept backup offers
• Defined parameters for buyer qualification
• Clear guidelines for canceling the contract and relisting their home

While a mortgage contingency or other real estate contract contingencies may appear to largely benefit buyers, these clauses can protect both parties in the long run, Ailion points out.

“A seller is concerned that contingencies take their property off the market, and if the buyer does not proceed, the home will appear stale or stigmatized,” Ailion says. “The flip side is that a well-prepared buyer is less likely to terminate due to a failed contingency.”

Common terms and conditions in loan contingency clauses

Most real estate contract contingencies dealing with mortgage financing include specific requirements and deadlines. Standard elements in a loan contingency include:

• Loan amount and loan type: This will state the maximum amount you were pre-approved for, the loan type, loan conditions, and your down payment requirements.
• Interest rate: Your mortgage rate could make your monthly mortgage payment unaffordable if rates move higher or you don’t qualify for the rate you expected. A loan contingency will specify the maximum interest rate you qualify for, rate lock requirements, and any provisions if rates fluctuate.
• Closing costs and origination fees: Your loan estimate and final closing disclosure lists out all of the fees and third-party costs of your mortgage. The buyer’s maximum budget for closing costs should be stated in the loan contingency.
• Mortgage contingency deadline: The clause should clearly state a specified approval deadline, closing date requirements, and extension provisions if you need more time to secure financing.

What happens if a loan contingency is not met?

If a buyer can’t secure financing by the loan approval deadline, things can quickly go south without timely communication.

“I’ve seen cases where proactive communication with all parties allowed for an extension, salvaging the deal,” Renwick says. “However, if communication breaks down, the seller has the right to cancel the agreement and relist the property."

If a loan contingency isn’t met, here are three next possible steps:

1. Request an extension

If the buyer’s mortgage approval takes longer than anticipated, they can ask the seller for a deadline extension. However, this must be put in writing, and a clear deadline must be communicated. The seller could accept the request or decline and cancel the contract.

2. Withdraw from the purchase agreement

If your lender denies your loan or it’s more costly than you can afford, you can notify the seller in writing that you’re withdrawing your offer. You must do this within the contingency period, though, and you must provide loan denial documentation. Your earnest money will be returned.

3. Seek alternative financing with another lender

You can apply for a mortgage with another lender who can work with your situation. If you were denied due to lackluster credit or your debt-to-income ratio is too high, you might be able to find alternative lenders who’ll work with you. In this scenario, you still may need to get a deadline extension, as you’ll have to start the loan application process again from scratch.

Tips for managing loan contingencies in your real estate transaction

A loan contingency helps you avoid a last-minute catastrophe that could cost you thousands of dollars. Here are some tips for managing a loan contingency in your purchase offer:

1. Get pre-approved for a mortgage before making an offer.
2. Work with experienced mortgage and real estate pros.
3. Pay close attention to deadlines and key dates, and put everything in writing.
4. Keep detailed, up-to-date financial and employment documentation.
5. Respond quickly and truthfully to your loan officer’s questions.
6. Stay updated on local housing market conditions and mortgage rates.