A "mortgage contingency clause" is a provision in the home purchase contract that says that if the prospective buyer can’t get a mortgage within a fixed period of time, s/he can call the whole deal off. In other words, the agreement is conditional on the buyer being able to obtain a mortgage on the property. A “mortgage contingency clause”, also known as a “loan contingency clause”, is perhaps the most important provision in the purchase contract that a potential buyer of real property can have--almost equal to the home inspection contingency.
Typical terms in a purchase contract made by the buyer for property contain what is called an “active contingency waiver”. An “active contingency waiver” is a provision in a contract requiring the buyer in writing to “cancel” a specified condition for the property’s purchase (for example, a loan financing commitment by a lender) in order for the sale to go forward.
In contrast to an “active contingency” is a “passive loan contingency.” An example of a “passive contingency” is as follows: “buyer will close escrow on the designated property on the date agreed upon unless the buyer within 25 days before the agreed upon date to close escrow notifies seller in writing that buyer has no loan commitment by a lender to purchase the property.” In this situation, if the buyer fails to give notice to the seller that s/he has no loan financing commitment by the agreed upon date, the buyer is bound to buy the property without financing in place.
Sentiment is that a buyer should always have an “active contingency waiver” in the purchase agreement because they are in control of rreleasing the contingency.. The reason is that many times a buyer will not carefully read the purchase agreement containing a “passive contingency waiver” with a deadline. If the designated contingency (i.e, loan commitment approval) is no longer applicable, but the buyer does not remove the financing contingency, the buyer is on the hook. If the buyer fails to advise the seller that he or she is not waiving the loan commitment contingency in writing, the safeguard for the loan commitment is lost and the buyer would be required to buy the property even if he or she does not have a committed financing in place. Many times buyers and their real estate agent simply forget about the passive contingency, the time to stop its release passes and the buyer is then stuck.This obviously can lead to serious problems for the buyer.
In a nutshell, a “loan contingency clause” is a clause in the purchase agreement for real property that safeguards a buyer that if s/he applies for a loan but is unable to obtain a firm commitment from a lender for the loan to buy the property in a set time period, then the buyer has the option to not close the sale. The result is that the buyer is entitled to a refund of his full down payment.
A commitment letter from a lender to a buyer is entirely different than a pre-approval letter. A pre-approval letter from the lender to the borrower is not binding as opposed to a commitment letter stating the agreed upon terms of the approved loan are binding. Consequently it is very important for any borrower to have a loan contingency clause in his or her offer to purchase real property, requiring a commitment lender from a lender as a condition to purchase the desired property.
All real estate buyers should demand a loan contingency clause since it provides him or her additional protection if they need financing to close the sale. Sellers typically wish to avoid such a contingency because the sale may be delayed due to the loan approval process. Or worse, having to find an alternate buyer if the buyer cannot obtain loan approval.
The need for a “loan contingency clause” and its acceptance by the seller as a condition for the property’s sale depends upon numerous factors consisting of real estate market conditions (strong seller’s market, strong buyer’s market, strong lender’s market or the opposite of these examples), the appraised value of the property, the amount of the loan, and the financial strength of the buyer. For example, in a strong buyer’s market, the seller is faced with few offers for his property at the price desired and consequently will be more willing to accept a loan contingency as a condition for the sale as opposed to a string seller’s market where the seller is faced with multiple offers to purchase typically above the initial asking price.
In a weak seller’s market scenario, the seller most likely will be forced to accept a loan contingency for the sale to go through or risk the possible sale of the property. In most loan contingency provisions, the seller wants as short of a period for approval while the buyer wants as long of a period. In any event, the buyer should insist upon a commitment letter by the lender as part of the loan contingency agreement to ensure that he gets the loan before waiving this contingency. The best course of action for the buyer is to have -- up to the escrow signing date-- to formally waive the loan contingency to ensure that the sale will close or not, and if not, to safeguard against the loss of the
Conclusion
Be cautious. There is no universal "standard" mortgage contingency clause. The seller would prefer that the sale close no matter how high the interest rate and how horrible the terms the mortgage carries for the buyer. The buyer wants to be sure that if s/he can’t get the mortgage s/he is counting on, such as one with 90% financing on a 30-year loan, the mortgage at no more than X%, s/he can walk away from the transaction and recover the down payment. The seller may be concerned that the buyer is leaving the transaction too uncertain. Thus these provisions are often negotiated.