Understanding the Financing Contingency

As we have mentioned in other blog posts, an offer to purchase is a promise to buy a property.  Once that offer is officially accepted by the seller, it becomes a contract.   Contingencies in the contract are the buyer’s way of saying “I promise to buy your property, but only if…”

Today’s article will be about the financing contingency in a real estate contract.  When reading the contract, it becomes immediately apparent that this subject is a little more complicated than one may think, and this article aims to clarify all the subtle details, and impart an understanding of the importance of attention to those details.  Let’s get started!

At its core, the financing contingency protects the buyer from being compelled to move forward with a home purchase in the event that they are unable to procure financing.  Imagine a scenario where your offer to purchase a home was accepted, but two weeks later you lost your job and were unable to qualify for a loan.  If still under obligation to purchase the home, you’d have to find a way to come up with cash to pay for the property, which would likely be an impossible challenge to overcome.  This would put you at considerable legal and financial risk.  For this reason, most buyers who intend to finance their purchase include a financing contingency.

Here is some of the specific language from the Wisconsin contract:

“This offer is contingent upon Buyer being able to obtain a written _______ [type of loan or specific lender, if any] first mortgage loan commitment as described below, within _______ of acceptance of this Offer.  The Financing selected shall be in the amount of not less than $__________ for a term of not less than _____ years, amortized over not less than _______ years.  Initial monthly payments of principal and interest shall not exceed $______. “

This language clearly states that the buyer promises to purchase the property ONLY IF they are able to qualify for the type of financing described.  There is also a timeline associated with approval for this financing.   The loan terms are very important details to which special attention must be paid by buyers writing offers or seller evaluating and considering whether to an accept an offer or not.  Let’s look more closely at some of these details:

• “obtain a written ____ [type of loan or specific lender, if any]”: Type of loan refers to conventional, VA, FHA, or other types of loan programs.  If the buyer is able to qualify for one type of loan but not for the one listed here, they may not be obligated to move forward with the transaction.  Furthermore, the buyer may also stipulate, if they wish, that they must be approved by a specific lender.  A seller would be well advised to ask a few questions before accepting an offer that is contingent upon approval by a particular lender, just to be sure they are comfortable with the terms and associated risks.
• “within ____ of acceptance of this Offer”: This will determine the deadline by which the buyer must be provided a letter of loan commitment from their lender.  It’s important for a buyer to establish reasonable expectations with their lender.  If the timeframe provided here is too aggressive, and the lender is unable to complete their underwriting process in time, it could create avoidable challenges down the road.
• “not less than $_____”:  This shows the minimum loan amount for which the buyer must be approved.  Subtracting this amount from the purchase price will provide the amount of the down payment which the buyer intends to make.  When writing an offer, it’s important for a buyer to accurately represent how much they need to borrow.  If they are approved for 80% of the purchase price but only have 10% of the in the bank available for a down payment, it will be difficult to move forward.  For a seller evaluating an offer, this number provides valuable information.  The amount a buyer intends to put down toward the purchase is often a good indication of their financial strength.  Financially strong buyers present less risk to sellers in terms of terminated contracts, which cost time and money.  A seller may prefer an offer with a higher down payment over those with little or no down payment for obvious reasons.  On the other hand, if an offer shows that the buyer intends to borrow less and pay more money up front, it may behoove a seller to request proof of funds for the down payment amount.  A buyer promising to borrow just $300,000 for the purchase of a million dollar home cannot expect a seller to take it on faith that the other $700,000 is available, and should be prepared to present satisfactory documentation to the seller upon request.
• “for a term of not less than ___ years, amortized over not less than ____ years”: The typical home mortgage term is 30 years, but there are other programs available for 15 years or less.  The interest rates on these loans may often be lower than 30 year loans, but they, by definition, must be paid off faster.
• “initial monthly payments of principal and interest shall not exceed $___”: This number is actually going to be a function of the terms above, along with the interest rate (discussed later).  To determine the monthly payments a buyer will make, there are online tools available which will calculate the exact number based upon loan amount, length of the loan, and the interest rate.  As a seller, it’s a good idea to check and make sure that the maximum monthly payment amount listed here matches the other terms of the offer.  If the monthly payment listed is lower that what would be expected for the loan described, it could give the buyer an unexpected opportunity to terminate the contract, thus creating a negotiating disadvantage for the seller.  You can click HERE to use the financial calculators page on our website.

Many times the final purchase price for a property is different from the number on the original offer.  The price can change as a result of counter-offers or amendments.  To avoid the necessity for adjusting all the numbers above, there is language in the financing contingency which automatically adjusts the numbers to a percentage equivalent in the event that the purchase price is adjusted.  The loan as a percentage of the purchase price shall remain the same, and the monthly payment shall be adjusted accordingly.

The following lines of the inspection contingency allow the buyer to indicate the interest rate which they must qualify for.  The buyer must first indicate whether it will be a fixed or adjustable rate loan.  If the loan will have an adjustable rate, the terms of that program must also be entered in.  In either case, however, it’s important to note that the interest rate indicated in this section is the maximum rate which the buyer is willing to accept.  If the offer states 6% but the buyer can qualify for 5.5%, all is well.  If the offer states 6% and the rates rise over the following weeks, and the buyer is only able to qualify for 7%, however, the buyer will likely have the opportunity to terminate the contract, leaving the seller to re-list the property and search for another buyer.  It’s always a good idea for sellers to check with their Realtor to see what current interest rates are.  If an offer indicates an interest rate lower than expected, a call to the buyer’s lender may be in order to confirm whether that rate will be available to the buyer or not.  Checking things like the length of the loan, or whether it is fixed or adjustable rate may help explain how certain lower rates can be available, but talking with the lender may be the best way to be sure.

When we say a contingency has been satisfied, we mean that the conditions set forth in the contingency have been met and that the transaction can move forward as planned.  For the financing contingency to be satisfied, the buyer must deliver a written loan commitment to the buyer before the contingency deadline.  That loan commitment must either be signed by the buyer or accompanied by a signed notice from the buyer giving instruction to their agent to deliver the commitment.  The moment that a loan commitment has been delivered to the seller, the buyer loses the protection provided by the contingency, so it is very important that a Realtor does not share the letter without expressed written permission from their client.

The financing contingency is different from most other contingencies in that it also affords the seller termination rights.  If the buyer fails to provide the seller with a loan commitment before the deadline, the seller will have the right to terminate the contract by issuing a notice of termination to the buyer BEFORE the buyer delivers a loan commitment letter.  Even if the buyer provides a loan commitment letter 3 days after the deadline, the seller will no longer have the right to terminate once that commitment is received.

In the event that the buyer is NOT approved for a loan on the terms stated in the offer, it is the buyer’s responsibility and obligation to promptly deliver written notice to the seller that financing is unavailable, along with a letter of rejection from their lender.  Since the contingency has not been satisfied, the buyer will have the option to terminate the transaction, but MAY choose to work with the seller to find an alternative solution, should both parties come to an agreeable plan.

Hopefully this article helps you to understand the subtleties of the financing contingency and ways to use and interpret the information therein to evaluate the terms of an offer.

Stay tuned for future posts covering related topics like pre-approval letters and proof of funds!

If you have any questions about financing contingencies, please let us know! We’d love to hear from you!