Why a Home Buyer Should Request a Loan Contingency
Having a loan contingency clause in a home sales contract ensures that the buyer will be freed from any obligation to purchase the home if something goes wrong in the loan approval process. A buyer should make sure a loan contingency—also called a mortgage or financing contingency—is included in their contract if they have any doubt about their ability to obtain a mortgage.
This kind of clause also usually lays out the amount of the down payment the buyer will make and the type of mortgage the buyer hopes to obtain. It should cite the length of the loan and its interest rate. These provisions protect buyers from having to pay back a loan they can't afford if they can't obtain a mortgage that meets these requirements.
Canceling Without Forfeiting Earnest Money
The types of purchase contracts used in the U.S. can vary from one state to another, but most allow for a loan contingency period during which the buyer must obtain the financing necessary to complete the home purchase. The buyer must notify with seller within this time period if they haven't been unable to do so.
The timeframes are often stipulated. A buyer might be required to tell the seller that they haven't gotten a mortgage at least 30 days before the sale is scheduled to close. Either party can then terminate the contract.
The buyer can cancel the contract without forfeiting their earnest money deposit if they're unable to obtain a mortgage and they've made the necessary disclosure to the seller within the stipulated period of time. Otherwise, the contract moves forward and the earnest money is moved into a special, dedicated account pending closing.
Earnest money is typically held by the agent or broker at the time a buyer makes an offer to indicate that they're serious about purchasing the home. It's usually payable to a title company, escrow company, or the brokerage. The amount of the deposit is credited to the buyer at closing.
A buyer must typically make a good faith effort to secure financing. They can't do nothing or make a halfhearted effort as the contingency period ticks down. They must submit a loan application and cooperate with the lender to provide all requested documentation so the loan can be approved.
Some states stipulate that the loan amount must be no more than that which is required to finance the property.
Active vs. Passive Contingencies
The removal of a loan contingency from the contract can happen in one of two ways. One is more favorable to the buyer and the other is more favorable to the seller.
The seller must request that the contingency be removed from the contract after it has expired if the loan contingency was written to be the active type. This type of loan contingency can give the buyer extra time to obtain a mortgage if the seller, their agent, and their attorney don't act quickly enough to remove the contingency.
The seller might issue a "Notice to Buyer to Perform" (NBP) in some states when the contingency period has expired, giving the buyer an initial day or two to get financing in place. The seller is free to cancel the contract after this additional time has passed if the buyer is unsuccessful in securing a loan.
The contingency expires without the seller having to request it if the buyer hasn't been able to obtain financing and has failed to notify the seller. This type of removal is passive, and the buyer can still be contractually obligated to buy the home. The loan contingency backfired on the buyer in this scenario.
The buyer could lose their earnest money and leave themselves open to a lawsuit by the seller if the contingency simply expires.
Requesting an Extension
The buyer might still want to purchase the house after an active loan contingency has been removed, and they might continue to try to secure financing for the purchase. They can request more time to get a mortgage, but the seller is under no obligation to agree to an extension.
The buyer might be required to put down more earnest money in exchange for extra time.
A Possible Downside
A loan contingency clause could contain a downside for the buyer. They should pay close attention to what they're required to do under the terms of the contingency, because they might be obligated to purchase the home even if they've been unable to obtain a loan if they make a mistake.
North Carolina Real Estate Commission. "Questions and Answers on: Offer and Acceptance." Page 4. Accessed May 31, 2020.
National Association of Exclusive Buyer Agents. "Complete Guide to Buying a House." Accessed May 31, 2020.
Realtor.com. "What is Earnest Money and How Does It Work?" Accessed May 31, 2020.
National Association of Exclusive Buyer Agents. "What Is the Mortgage Contingency Clause and Why Is It a Bad Idea to Waive It?" Accessed May 31, 2020.
California Association of Realtors. "Contingencies and Cancellation." Accessed May 31, 2020.
American Financing. "What is a Mortgage Contingency Agreement or Clause?" Accessed May 31, 2020.