When you sign a purchase contract, you’re signing a legally binding agreement. Most of the time you also put down earnest money. If you back out of the contract without any reason that’s legally backed, you lose your earnest money, which could be thousands of dollars.
Since buying a home is one of the largest purchases you’ll make, you want to enter the contract carefully. You sign a contract that doesn’t work in your favor, but you also don’t want to have so many contingencies that a seller won’t accept your bid.
One of the most popular contingencies you can add to a purchase contract is a financing contingency. Understanding what it is and how it works is important.
What is a Financing Contingency?
A financing contingency gives you a chance to back out of a purchase contract without losing your earnest money if you can’t finalize your financing.
It’s a deal with the seller letting him/her know that you’ve already secured a preapproval from a lender, but you don’t have final approval yet and want a way to back out if something comes up and the lender turns your application down.
How Does it Work?
A financing contingency is very detailed. It lets the seller know what terms you’re preapproved for and what you can accept and still move forward with the sale. This way if any of the terms don’t end up working out, you can back out of the sale.
Some of the most common terms included are:
- Loan amount – This lets the seller know how much you need to borrow in order to buy the home. If the lender can’t approve you for that loan amount, you’d need to back out of the sale.
- Mortgage type – This refers to the type of mortgage you’re getting, whether it’s conventional, FHA, VA, or USDA. Some sellers won’t accept certain types of financing, such as VA, so this is an important factor.
- Term – This is how long you will borrow the money. If you apply for a 15-year term, but then can’t get approved for it, you can back out of the sale, or you could try to get a 30-year term.
- Interest rate – If you didn’t lock your rate in yet and rates increase a lot, you can back out of the sale because the rate won’t be what the lender approved you for.
Who Needs a Financing Contingency?
Anyone that is financing the purchase of a home could use a financing contingency. Even if you have great credit and a large down payment, things could still go wrong. There’s never a solid guarantee that you’ll close on your loan until you have the final approval.
Lenders can’t give final approval until they have all conditions satisfied on your loan and that includes factors that affect the house, such as the appraisal and title work.
Unless you’re paying cash for the property, a financing contingency could help. If you know beyond a reasonable doubt though that the financing will go through or that you have options, you might skip it.
If you’re Pre-Approved, do you need a Financing Contingency?
It might seem that if you’re pre-approved you wouldn’t need a financing contingency, right?
Anything can still go wrong with a loan after pre-approval.
A pre-approval is conditional approval. It tells you what you are approved for based on what the lender has seen so far and what conditions they require. Your pre-approval letter will include all the conditions you must meet to get the final approval.
If you have a lot of conditions that pertain to your finances or your personal situation, you might want the financing contingency in case the lender finds a reason to turn your loan down.
After pre-approval and once you sign a purchase contract, lenders run more checks that are more detailed to make sure you are a good risk. This could include verifying your employment, getting your tax transcripts, or digging deeper into any child support or alimony situations.
Even one small factor could cause a lender to turn your pre-approved loan down so don’t assume that you are in the clear until you have that final approval.
Do Sellers Like Financing Contingencies?
To put it simply, sellers don’t like any contingencies.
A contingency gives you a way out of a contract. If everything doesn’t go perfectly, you can back out, leaving the seller back at square one. Sellers don’t often want to take that chance. Because the contingency gives you the chance to back out and keep your earnest money, the seller really comes out on the losing end.
Most sellers assume if you want a financing contingency that you’re worried your financing won’t go through. That’s not very reassuring for sellers so they may choose another offer that doesn’t have the contingency.
Even a borrower that seems like a great fit can run into unexpected trouble and possibly not get approved for the loan.
How do Financing Contingencies Compare to Other Contingencies?
Financing contingencies aren’t the only contingencies you can have. There are several others that sellers dislike just as much.
Many people confuse the financing contingency with the appraisal contingency, but they are different. An appraisal contingency gives the buyer the chance to back out of the sale if the appraisal comes in low.
For example, if you bid $200,000 for a home and signed a contract for that amount but the appraiser says it’s worth $175,000, the lender will use $175,000 as the amount to base your loan amount off of.
This leaves you without the $25,000 difference. If you don’t have an appraisal contingency, technically you’re still on the hook to buy the property at the agreed price. This could lead to financial trouble if you buy a home for more than it’s worth.
You have options before you back out of the sale, though. You can try renegotiating the sales price with the seller to meet the appraised value or you could decide to pay the difference between the appraised value and sales price if it’s not too high.
Without the contingency, the only way to back out of the contract is to lose your earnest money deposit.
Home Inspection Contingency
The home inspection contingency gives you the option to back out of a contract if the home inspection comes back with bad news.
You get a certain amount of time, usually 14 days to have the inspection completed and to review the report. If the inspector found major issues with the home, you could back out of the contract and keep your earnest money.
Like with the appraisal contingency, you may be able to work something out with the seller if the inspection finds major issues with the home. You may ask the seller to fix the issues or if it’s something that won’t affect financing and/or the appraisal, you can ask for a credit at the closing and fix the issues yourself.
Home Sale Contingency
If you currently own a home and need the proceeds from the sale to buy the new home, you may want a home sale contingency. This gives you a certain amount of time to sell your home to make it all work. If the home doesn’t sell by the date of the contingency, you can back out of the contract, keeping your earnest money.
A home sale contingency is one contingency sellers typically don’t like. There are too many variables involved that allows you to back out of the sale.
If sellers are faced with an offer with a home sale contingency and one without, they usually choose the one without even if it’s for a lower amount.
Clear Title Contingency
One last contingency that isn’t as common is a clear title contingency. This can overlap with a financing contingency because, without a clear title, a lender can’t give you final approval.
A clear title contingency means if the title examiner can’t get a clear title because there are liens on the property or issues with the chain of title, you can back out of the sale. This might sound better than a financing contingency, but it has the same ‘theory’ since lenders can’t lend money without a clear title.
Protecting yourself when you sign a purchase contract is important. Too many contingencies, though, could leave you without a home to buy. Work with your attorney to determine which contingencies are the most important to have on your contract.