What Is a Loan Contingency?
Buying a home is a major financial undertaking for both the buyer and seller. Often, unforeseen hurdles may deter buyers from moving forward with the sale. In these cases, loan contingency clauses can protect both parties.
If you’re looking to buy a home, then there is every chance you have heard of the term “loan contingency” – in this guide, we’re exploring what it means for your mortgage loans and other forms of lending.
What Is a Loan Contingency?
Real estate contracts often include loan contingency clauses to protect buyers and sellers. Like escrow, the clause requires stipulations and requirements the buyer must meet before the sale is approved and completed. Typically, contingency clauses require:
- Home inspections
- Appraisals
- Sale of buyer’s previous residence
- Buyer to obtain a loan
If the buyer is unable to meet the requirements, both parties may back out of the contract. The seller will retain their property rights and can relist their home. Similarly, the buyer will not be obligated to purchase the property and can receive their earnest money deposit, or down payment, back.
How Does It Work?
Loan contingency clauses are between 30 and 60 days. During this period, specified criteria need to be met to complete the transaction. However, both parties may pull out of the deal within this timeframe.
The buyer and seller must agree on the requirements and conditions in the loan contingency clause. Some of the details include:
- Type of mortgage the buyer must secure
- The specific loan amount the buyer must be approved for
- The interest rate of the loan
- Additional fees
- Timeframe
Contingency clauses are common practices when the buyer is uncertain whether they will receive a home loan. However, these clauses are also used as security precautions when obtaining mezzanine loans for businesses.
Financial Contingencies
Financial contingencies can be used to see if the buyer can obtain adequate funds to purchase the property. For example, some buyers may need to take out personal loans, while others will likely need to secure a larger loan. Therefore, the seller can choose to include financial stipulations in a loan contingency clause to confirm the buyer’s financial security before completing the sale.
If the buyer doesn’t qualify for a loan, they will not fulfill the financial contingency requirements. As a result, the seller can back out of the deal without repercussions.
In addition to financial contingencies, there are other types of requirements for these clauses. For instance, buyers may include an appraisal contingency. They may want to verify the purchase price of the home through independent valuation. If the appraiser does not value the property for the purchase price, the buyer can back out of the contract without losing their down payment.
Although rare, not all contracts include a loan contingency clause. However, most parties choose to include them as a precautionary measure.
Active vs. Passive Contingencies
Loan contingency clauses can either be actively or passively lifted.
Active contingencies are removed through explicit release. Both parties must agree in writing for an active contingency to be lifted. For example, if the contract includes an active 30-day appraisal contingency, the clause will remain even after the thirtieth day.
Conversely, a passive contingency is lifted automatically once the deadline passes. As a result, the contingency is removed by default. Conversely, if the contract included a passive 30-day appraisal contingency, the clause would be lifted after the thirtieth day.
Requesting an Extension
If both parties agree, a loan contingency clause can be extended. For example, if the buyer requires more time to secure a loan, they may request an extension. Typically, extensions require the aid of a lawyer to file additional paperwork. Moreover, the party seeking an extension may need to pay additional fees.
In some instances, it would be beneficial to both parties to extend the contingency clause. For example, if the buyer is finalizing their loan agreement, both sides may prefer an extension. The buyer can ensure they don’t lose out on their dream home, and the seller avoids securing a new buyer.
Contingencies in a Buyer’s Market vs. a Seller’s Market
In a buyer’s market, the contingency clause could afford the buyer more protection. An eager seller who wants to make the sale may allow the buyer to include more contingencies in the contract.
Conversely, in a seller’s market, the contingency clause will likely not be in the buyer’s favor. In this type of market, sellers may be less inclined to offer lenient contingencies for buyers to get out of a contract without penalty because they will likely be able to secure another buyer quickly.
Final Thoughts
A loan contingency is a way to protect yourself in the agreement, and it means that if the other party doesn’t match your expectations, there is an opportunity to pull out of the deal with no penalties.
Contingencies need to be agreed upon beforehand, so make sure you think carefully about it and pay close attention to what goes into the contract before signing an agreement.
If done correctly, loan contingencies are a fair way and effective method to allow you to have a little bit of extra protection.
