The Loan Contingency - Why it Matters

There are several contingencies in a standard Real Estate Purchase Agreement. One of the main contingencies is the loan contingency. Basically, the buyer will specify the terms of the purchase on the first page of the purchase agreement, including the loan amount, as well as the terms of the financing the buyer is attempting to obtain. The intention is for the transaction to be contingent upon the buyer’s ability to obtain financing at the rate and terms indicated in the purchase agreement, as well as the loan amount. So why does it matter?

The loan contingency and stated terms of the financing section protects the buyer against sharp increases in interest rates or unanticipated changes in loan terms. For example, the buyer may have stipulated a loan amount of $900,000 at a rate not to exceed 5.5% fixed with 0 points. If the buyer is not able to obtain a $900,000 loan at the stipulated rate and terms, then the buyer may cancel the agreement. For example, if rates shoot up and the market rate becomes 6% for this loan, the buyer will not be obligated to proceed. Obviously, the buyer can still elect to move forward in this situation, but they are not obligated to.

As a seller, you should insist on a pre-qualification letter, or better yet, a pre-approval letter from a lender indicating that the stipulated rate and terms are obtainable at the time the buyer submits the offer. It is also important for sellers to pay attention to the financing terms specified. If the buyer stipulates an interest rate or terms that are not available today, you might be in essence giving the buyer a free option on the property, as they can indicate prior to contingency removal that they are unable to obtain this rate and terms, and thereby cancel the agreement. Make sure the rates and terms are achievable.

There is another side to this. Implied in any contract is the covenant of good faith and fair dealing. If a buyer purposely derails the loan process by not providing information to the lender, or instructing the lender not to order the appraisal, or otherwise sabotaging the process so they can claim that they were not able to obtain the loan, one could make a strong argument that the seller might be entitled to the buyer’s deposit on the basis that they acted in bad faith. Obviously, other factors outside the buyer’s control can also derail the loan contingency, such as a job transfer, loss of a job, or other financial catastrophe that makes it impossible for the buyer to obtain a loan. In these cases, the buyer can cancel the agreement if they have not removed their loan contingency.

Sometimes, Realtors do not stipulate the buyers rate and terms, and instead the buyer’s agent will add “buyer to obtain the best possible rate and terms available”. This can be dangerous, however, if rates shoot up or the lender the buyer was planning on using suddenly decides to discontinue the loan program the buyer was counting on. Strictly from a contractual perspective, that kind of language may obligate the buyer to get any loan available, regardless of the rate and terms, in order to fulfill the contract.

Lastly, the buyer should definitely lock in their loan rates and terms as soon as possible to prevent a situation where the rate goes up and they no longer qualify, especially if they have removed their loan contingency.

Like many clauses in the contract, the loan contingency is there to protect the buyer against unanticipated changes that might impact their capability or willingness to proceed with the purchase. Buyers should carefully consider the impact of this contingency, and (as always) consult with an attorney for advice relating to their specific situation.