How to Use a Loan Contingency When Buying a Home
It was once a fairly common practice for a home buyer to make an offer subject to the ability to get a mortgage, which was known then as it is now as a loan contingency. Times change and real estate markets typically dictate the type of verbiage and contract contingencies that are acceptable. A loan contingency today is often a bit tricky.
The reason for the challenges involves the type of loan contingencies most prevalent. In California real estate, for example, like many other places in the country, a home buyer might look at several types of loan contingencies and incorporate one or more of these contingencies into the purchase offer.
Only home buyers who are obtaining financing tend to make the purchase contract contingent on obtaining a loan. Cash buyers do not request a loan contingency because there is no loan. The contract might be contingent on the buyer obtaining an:
- FHA loan, which has its own set of requirements, or
- a VA loan, which is guaranteed by the Veteran's Administration, or
- a conventional loan, which is typically sold in the secondary market, or
- loan from a credit union where the borrower is a member, or
- private financing, which is sometimes called a hard-money loan
Depending on the type of loan, the lender might require certain property conditions or repairs to make the loan. If the sellers and buyers cannot agree on the repairs or lender conditions, the buyer will not receive the loan, and the transaction might fall apart.
Generally, the buyer has a certain time period in the purchase contract to obtain the financing. In some instances, the contract might give the buyer a choice, to choose between a certain number of days before the loan contingency will need to be removed or satisfied, or to keep the loan contingency, if all parties agree, in place until closing.
It is where the problem begins. Most sellers expect that a buyer will need to obtain financing. Sellers are typically somewhat reasonable and will allow a certain period of time to pass for the buyer to obtain the financing and remove the loan contingency, but not every seller will want to wait until the day of closing to find out if the buyer is indeed able to close escrow. It is not entirely fair to a seller for a buyer to ask for a 30-day closing period without a firm commitment to close. On the other hand, removing a loan contingency prior to closing can make a buyer very nervous.
A buyer might wonder what would happen if the lender, for some unforeseen or odd reason, decided to reject the loan. If the buyer had removed the loan contingency, the buyer might be at the seller's mercy, and the buyer's earnest money deposit could be at risk. Few buyers are willing to take a gamble on losing the deposit.
Of course, buyers obtain and present a pre-approval letter prior to making an offer. It is the preapproval letter the seller relies upon as proof of the buyer's creditworthiness and ability to qualify for a loan. But after the file is packaged for underwriting, other problems can pop up. Unknown judgments can appear in the public records, a buyer might have a blip on the credit report that had slipped through the cracks, an ex with a previous short sale can put a damper on qualifying, a buyer could lose her job, a buyer might be employed just under the required 2-year period or receive wages unreflected on payroll stubs. There are a bazillion things that can go wrong Let's not overlook that the second type of loan contingency is the appraisal. The appraisal contingency is often separate from the loan contingency. The appraisal contingency means the home must appraise at the purchase price. If the appraisal is less than the purchase price, then the buyer can cancel providing the buyer has an appraisal contingency in the purchase contract. If the seller agrees to lower the price to meet the appraisal, the buyer is then expected to remove the appraisal contingency.
But what happens if at closing the underwriter decides at the 11th hour to order a second appraisal and that second opinion of value turns out to be a low appraisal? If the buyer has released the appraisal contingency, there is no appraisal contingency left. However, if the loan contingency has not yet been released, the purchase contract may still be contingent upon the buyer's ability to get the loan.
These are concerns to be addressed with your real estate agent prior to making an offer to buy a home. Some buyers are comfortable removing a loan contingency when a lender assures the buyer the file is ready for funding. However, if the lender has concerns, it might not be a good idea to remove the loan contingency. Loan contingencies also speak to a seller. The downside is when your offer is among multiple offers, and the other buyers are willing to remove a loan contingency or shorten the period, and you insist on keeping the loan contingency intact all the way to closing, your offer might not get accepted. The seller might think you have a problem that could cause difficulties at closing.
In tough situations like these, some home buyers ask the lender to approve the file through underwriting before they ever make an offer to purchase a home. Underwriting approval removes the fear of uncertainty and strengthens the offer.