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 on a house before acquiring loan approval, known as a loan contingency. Many realtors require proof of mortgage pre-approval before making an offer on a home—some may not even work with you unless you do. A loan contingency today is often a bit tricky.
The reason for the challenges involves the type of loan contingencies that are most prevalent. For example, in many places throughout 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.
Contingencies can be part of your due diligence, and if not accomplished by either party can be contract-canceling events. As a buyer, it is important to understand these elements of home-buying, and how they work. The two general types are financial contingencies and appraisal contingencies.
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
- A VA loan, which is guaranteed by the Veteran's Administration
- A conventional loan, which is typically sold in the secondary market
- A loan from a credit union where the borrower is a member
- Private financing, which is sometimes called a hard-money loan
- The home appraisal
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 will be voided.
Obtaining a loan is generally part of a buyer's due diligence.
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 between a certain number of days before the loan contingency will need to be satisfied or to keep the loan contingency in place until closing.
Contingent Upon Loan Financing
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. However, 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, if a seller removes a loan contingency prior to closing, a buyer might become very nervous.
Lengthy closing periods make sellers nervous, as it appears that a buyer may not have the means to purchase or make an offer.
A buyer might wonder what would happen if the lender decided to reject the loan for an unforeseen reason. Or, if the buyer had removed the loan contingency, they might be at the seller's mercy, and their earnest money deposit could be at risk. Few buyers are willing to take a gamble on losing their deposit.
Many buyers obtain and present a pre-approval letter prior to making an offer. It is the preapproval letter the seller sometimes relies upon as proof of the buyer's creditworthiness and ability to qualify for a loan. However, after the file is packaged for underwriting, other problems can pop up that will stall the process.
Pre-approvals simply state that a buyer basically has the income to support a mortgage payment, without considering any other factors.
Pre-approval is not a guarantee of loan approval. Title searches are conducted, as well as credit and income checks. Unknown judgments against the property can appear in the public records, or a buyer might have a blip on the credit report that had slipped through the cracks.
Don't overlook the second type of loan contingency—the appraisal. The appraisal contingency is often separate from the loan contingency. An 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 eleventh hour to order a second appraisal and that second opinion of value turns out to be a lower value? If the buyer has released the appraisal contingency, there is no appraisal contingency left.
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.
Some Final Thoughts
The downside of loan contingencies is if your offer is among multiple offers, the other buyers might be willing to remove a loan contingency or shorten the period. In this circumstance, if you insist on keeping the loan contingency intact all the way to closing, your offer might not be accepted.
If you hold on to your contingencies, the seller might think you have a problem that could cause difficulties at closing, or believe you to be too difficult to close with.
In tough situations like these, some homebuyers could ask their lender to approve the file through underwriting before they make an offer to purchase a home. Underwriting approval removes the fear of uncertainty and strengthens the offer.