How to Use a Loan Contingency When Buying a Home

It was once a fairly common practice for a homebuyer to make an offer on a house before getting loan approval. This is also 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 common. For instance, in many places throughout the country, a homebuyer might look at several types of loan contingencies. Then, they may incorporate one or more of these contingencies into the purchase offer.

Contingencies can be part of your due diligence. If not accomplished by either party, they can be contract-canceling events. As a buyer, it is important to know how these elements of homebuying work. The two general types are financial contingencies and appraisal contingencies.

Financial Contingencies

Only homebuyers who are getting 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 often 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. The transaction will be voided.

The buyer has a certain timeframe in the purchase contract to obtain the financing. In some instances, the contract might give the buyer a choice: There might be a certain number of days before the loan contingency will need to be satisfied, or they can 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 often fairly reasonable. In many cases, they 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 very 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.

A buyer might wonder what would happen if the lender rejects the loan for an unforeseen reason. Or, if the buyer had removed the loan contingency, they might be at the seller's mercy. In that case, their earnest money deposit could be at risk. Few buyers are willing to take a gamble on losing their money.

Mortgage Preapproval

Many buyers obtain and present a preapproval letter prior to making an offer. The seller may rely on the preapproval letter as proof of the buyer's creditworthiness and ability to qualify for a loan. But after the file is ready for underwriting, other problems can pop up that can stall the process.

Preapproval 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 their credit report that had slipped through the cracks.

Appraisal Contingency

Don't forget about 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.

Second Appraisal

But what happens if at closing the underwriter decides at the last minute to order a second appraisal? And what if 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.

These are concerns you should discuss with your real estate agent before you make an offer to buy a home. Some buyers are OK with removing a loan contingency when a lender assures the buyer the file is ready for funding. But 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 Bottom Line

There can be downsides to loan contingencies. For instance, is if your offer is one of many, the other buyers might be willing to remove a loan contingency or shorten the period. In this case, 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, they might 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; it also strengthens the offer.

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