Loans

What Is a Loan Contingency?

During the home buying process, the buyer and seller must decide whether to use contingencies in the purchase contract. Mortgage contingency clauses can significantly benefit the buyer, but what is a loan contingency? 

What Is a Mortgage Contingency? 

What is loan contingency? If you want to start the house-buying process, it’s critical that you know what a loan contingency is. A loan contingency is a term or condition in a real estate contract that voids the property sale without penalty if those conditions aren’t met.

There are various types of contingencies, and you should be aware of them since they provide a safety net for buyers. In the event of an unforeseen issue, a mortgage contingency clause allows you to back out of buying a home. For example, an inspection contingency can help you avoid purchasing a home with extensive termite damage. 

There are active and passive contingencies on a purchase contract. An active loan contingency requires you to release the loan contingency clause. If you don’t actively remove the clause by the deadline, it remains in place. But a passive contingency is automatically removed once the deadline passes. Suppose you have 30 days to get financing, but you can’t get approval from the mortgage lender. In that case, you risk losing your earnest money deposit with passive contingency removal. Active loan contingency removal is safer, but it requires additional paperwork.

The period between the contract signing and the closing date is the escrow period. During the escrow period, the prospective buyer and the seller work together to settle each mortgage contingency. However, each mortgage contingency clause will have a deadline attached to keep the home-buying process moving. What if the seller or buyer cannot come to an agreement before the end of the contingency period? In that case, either party can negotiate or back out of the home purchase agreement. As a buyer, a contingency clause can help you get your earnest money back from the title company or real estate agent! 

What Is an Earnest Money Deposit?

An earnest money deposit is a lump sum you provide during the home buying process to prove you are serious about buying the property. However, the earnest money is not the same as the down payment. 

An earnest money deposit helps fund your down payment and other expenses. Your deposit is typically kept in a title company trust account or the broker’s escrow company account. While you could try making a purchase offer without an earnest money deposit, know that most sellers won’t accept bids without earnest money attached. But if a seller accepts your purchase offer with a deposit, that money will go towards your down payment and closing costs.

There is no set amount of money you should provide as an earnest money deposit. But typically, buyers offer between 1% to 3% of the home’s purchase price. If your desired home is $250,000, you should prepare to provide at least $2,500. You can use loans with monthly installments if you don’t have that much money to provide out of pocket. Keep in mind that you are more likely to win a bid for a property if you offer additional earnest money.   

Mortgage contingencies are necessary because you can risk losing earnest money without them. For example, an inspection contingency protects you and your cash investment if the property fails a home inspection. If the house has severe water damage, a contingency clause allows you to retract your offer and get your full deposit back.     

Types of Real Estate Contingencies

You can add different types of mortgage contingency clauses to a real estate purchase contract as a buyer. Below are some common contingencies you can add to a real estate contract. 

Financing Contingency 

A financing contingency is a clause that allows the cancellation of the sales contract without penalty if you are unable to secure financing for the house. While most home buyers get preapproval from a mortgage lender before house hunting, loan approval is not guaranteed. You can get preapproved to get a house loan with bad credit, but you might get less than the estimate. And the worst part is that your credit score will go down after it’s checked!    

Suppose you get preapproval from a lender for a $200,000 mortgage. When you provide additional income documentation, the mortgage lender may only offer $150,000. A financing contingency allows you to cancel the contract and still receive your earnest money deposit.  

Buyer’s Inspection Contingency

You do not have to complete a home inspection before making a purchase offer, but it’s in your best interest to have one. Thorough home inspections can help uncover unseen issues and life-threatening problems with the real estate property. Knowing precisely what’s wrong with the home can help you decide if the investment is worth it. 

An inspection contingency conditions the closing process on the buyer’s satisfaction with the home inspections. An inspection contingency clause allows you to finance one or multiple home inspections during the inspection period. If the inspector discovers a serious defect, you can negotiate with the seller or cancel the purchase agreement. During negotiations, you can request repairs or a price reduction on the listing price. 

Insurance Contingency

Prospective buyers can add an insurance contingency clause to purchase contracts. Certain states are prone to natural disasters, and thus many insurance companies will not offer coverage. An insurance contingency allows you to cancel the contract if you can’t get approval for homeowners’ insurance. You may want to buy a home in California, but due to fires, earthquakes, and drought, you may have difficulty getting homeowners’ insurance with an adequate policy.   

Appraisal Contingency

During the approval process for a mortgage loan, the lender may send an appraiser to evaluate the property and determine the market value. The appraised value may be lower than the listing price of the home you want. In that case, the lender may not fund the mortgage loan. For example, you may want a $350,000 loan to buy a gorgeous farmhouse, but the appraisal shows the home is truly worth $200,000. An appraisal contingency protects you from buying a house worth less than what you would pay. 

Can I Waive a Mortgage Contingency?

As a buyer, you have the ability to waive one or more mortgage contingencies during the home-buying process. Establishing a mortgage contingency can complicate the home-buying process and take a lot more time. However, mortgage contingencies offer buyers financial protection during the real estate transaction. Removing a loan contingency means you are forgoing a safety net. 

The benefit of waiving a mortgage contingency is that you may win a bidding war and shorten the home buying process. If a seller wants to sell quickly, they may prefer to work with a buyer willing to speed up the home-buying process. For example, waiving an appraisal contingency is great for the seller! In the event of a low appraisal, the seller does not have to renegotiate the sales price or find another buyer willing to pay the listing price. When you waive the appraisal contingency, you have a greater chance of winning in a multi-offer situation. 

A home sale contingency stipulates that the buyer’s home must be sold before buying a new one. Waiving a home sale contingency makes sense if you are buying property for the first time and don’t require money from selling a previous house. Many sellers find home sale contingencies unattractive since they further complicate the closing process. If you don’t include a home sale contingency clause, but another buyer does, your offer will likely get accepted.   

There are certain instances when waiving a mortgage contingency makes sense, but more often than not, waiving a mortgage contingency can have negative repercussions. Suppose you are dead set on buying a property with multiple offers. To compete and be able to buy a house with bad credit, you waive the home inspection contingency. 

Skipping the home inspection is incredibly risky! Once you have the house keys in your hand, you may discover the house has toxic mold or severe foundation issues. Without an inspection contingency, you can back out of the purchase contract but at the expense of your earnest money deposit. That deposit can be worth thousands of dollars! 

If you can, avoid waiving any mortgage contingencies during the home-buying process. While mortgage contingencies complicate the process, the extra hassle can save you a lot of money. Suppose you waive a home inspection to avoid losing your dream home. You may later discover catastrophic issues that the seller or the inspector overlooked. In that case, know you can start a court case. Talk to an attorney to get legal advice and potentially get damages covered. 

The Bottom Line

A loan contingency clause can help prospective buyers back out of real estate contracts without penalties. While it’s tempting to waive certain contingencies in this competitive real estate market, don’t! Mortgage contingencies always work in the buyer’s favor and can help you get your full earnest money deposit back. 

References:
Contingencies to Include in Your House Purchase Contract│Nolo
The Earnest Money Deposit: How It Helps Buy a Home│Realtor
7 Types of Real Estate Contingencies and When to Waive Them│Accept.inc