Why a Home Buyer Should Request a Loan Contingency
Having a loan contingency clause in a home sales contract means that if anything goes wrong in the loan approval process, the buyer is freed from the obligation to purchase the home. If a buyer has any doubt about their ability to obtain a mortgage, they should make sure a loan contingency, which is also called a mortgage or financing contingency, is included in their contract.
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 intends to obtain, as well as the length of the loan and its interest rate. If the buyer can't obtain a mortgage that meets these conditions, they're protected from having to pay back a loan they can't afford.
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 if they make a mistake, they may be obligated to purchase the home even if they've been unable to obtain a loan.
Canceling Without Forfeiting Any Money
The types of purchase contract used in the U.S. vary from one state to another, but most of them allow for a loan contingency period during which the buyer must obtain the financing necessary to complete the home purchase or notify the seller they have been unable to do so. For example, the buyer might be required to tell the seller they haven't gotten a mortgage at least 30 days before the sale is scheduled to close.
If at that point in time, the buyer was unable to obtain a mortgage and has made the necessary disclosure to the seller, they can cancel the contract without forfeiting their earnest money deposit. (Earnest money is typically paid to a title company, escrow company, or real estate brokerage at the time a buyer makes an offer to indicate they are serious about purchasing the home.)
Active vs. Passive
The removal of a loan contingency from the contract can happen in one of two ways, one of which is more favorable to the buyer and one of which is more favorable to the seller.
If the loan contingency was written up to be of the active type, the seller must request for the contingency to be removed from the contract after it has expired. 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 to remove the contingency.
If the removal is of the passive type, 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, they can still be contractually obligated to buy the home. In this scenario, the loan contingency backfired on the buyer, who will lose their earnest money and leave themselves open to a lawsuit from the seller.
Requesting an Extension
The buyer may still want to purchase the house after an active loan contingency has been removed and might continue to try to finance the purchase. They can request more time to get a mortgage, but the seller is under no obligation to agree to an extension.