In early 2021, I was having a socially distanced coffee with my friend Sarah who’d just bought a house. In between sips of my latte, she was describing everything she and her husband Han did to make their offer as appealing to sellers as possible. “We even waived our financing contingency. That might’ve been what did it.” So what is a financing contingency in a home offer? Why did the seller of Han and Sarah’s new home get excited about them dropping it? And when is it safe for you to remove the financing contingency from your own offer? Let’s investigate.
What is a financing contingency?
A financing contingency, aka a loan contingency or mortgage contingency, is a clause within your home offer that lets you back out of the deal if you can’t secure your mortgage. It states to the seller:
“I’ve been preapproved for a mortgage, so I shouldn’t have any issues finalizing my mortgage and getting your money during closing… But if I do run into any issues with financing approval, this clause lets me back out of the deal without penalty and take my earnest money with me.” Your earnest money deposit is the 1% to 3% that you put on the house at the beginning of closing, also known as “good faith money.”
Financing vs. appraisal contingency
As a quick aside, your home offer may include several types of real estate contingency clauses that state: “If X condition isn’t met by the seller, the property, or even me as the potential buyer, I get to back out with my earnest money.” Your financing contingency is just one of them — not to be mistaken for your appraisal contingency, which states: “If the house’s appraised value is lower than the agreed-upon sale price, I get to back out and keep my earnest money.”
What goes into the financing contingency clause of an offer?
A thorough financing contingency typically includes the following key points:
- Your mortgage type – Conventional, FHA, etc.
- A deadline – Typically within 30 or 60 days of the seller accepting your offer.
- An amount – How much money you’ll need for a mortgage since you’ll have to back out of the deal if you’re approved for less.
- A term – 15 years, 30 years, etc.
- An acceptable interest rate – Pretty self-explanatory.
If you choose to include a financing contingency, you’ll want to spend time with your real estate agent to carefully tailor each term to your needs. Now, if you’re serious about buying a home in today’s competitive marketplace, getting a preapproval letter is a must. Submitting an offer without preapproval is technically still possible, but it’s like showing up to the Indy 500 in a Prius. A preapproval letter is a note from the mortgage lender to the seller that says, “I’ve looked over Chris’s finances and he’s good to go. We’re ready to loan him enough money to buy your house.” This begs the question:
If I’m already preapproved, why would I need a financing contingency?
It’s important to remember that a preapproval isn’t a promise. Even after preapproval, “there are many unknowns in the processing of a mortgage,” says Mark Milam, founder of Highland Mortgage. For example, your lender still needs to:
- Verify your self-employment income/rental income.
- Order transcripts from the IRS and scrutinize discrepancies.
- Run fraud checks (i.e., undisclosed divorces, child support obligations, etc.).
And much more. Plus, if you’re buying a condo, your lender now has to verify the structural integrity of the building before approving your mortgage — a rule laid out by Freddie Mac and Sallie Mae following the Champlain Towers collapse. So basically, there’s still a lot of paperwork to do between getting preapproved and securing the mortgage. That’s why most homebuyers prefer to keep their financing contingency in place — just in case there’s a hiccup, they want to be able to bail out without losing their earnest money.
Why aren’t sellers big fans of financing contingencies?
Let’s put you in the shoes of a seller for a second. You’re currently choosing between two offers:
- Offer 1 states: “I’ve got the cash right here.”
- Offer 2 says: “I should be able to come up with the cash by July.”
Which offer are you more likely to choose? Now, you probably realize that Offer 1 is coming from some wealthy-enough cash investor, while Offer 2 could be coming from a young couple just trying to buy their first home. Therefore, you might feel inclined to take Offer 2 on principle. However, accepting an offer with financing contingencies can be risky for sellers. While well-intentioned, the couple may run into issues with the IRS, or interest rates may have risen too high since their offer. Then, if they use their financing contingency to back out on day 30 of closing, you as the seller will have to relist your home for sale. That will not only increase its listed time on the market (DOM) by 30 days; it’ll now be branded as “relisted.” Therefore, even though it wasn’t your fault, having a buyer back out can actually lower the market value of your home.
That’s why sellers aren’t fans of financing contingencies: they let the buyer off scot-free and leave you with a mess to clean up. On the flip side, sellers love to see offers with no financing contingencies (or no contingencies of any kind). Because an offer with no financing contingency essentially means: “If we can’t buy this house due to financing issues, you get to keep our earnest cash (~$2,500 – $10,000).” Alrighty, now let’s put your buyer’s shoes back on. You know the marketplace is crazy, so you want your offer to look appealing to sellers. But at the same time, you don’t want to give up too many buyer protections and gamble your earnest money. So…
When is it safe to remove your financing contingency for a more competitive offer?
Removing your finance contingency means betting your earnest money that you’ll get approved for a mortgage. The challenge most buyers have with that idea calls back to Mark’s earlier comment — that there’s still lots of paperwork to be done between preapproval and final approval, and therefore, lots of little places where gremlins could hide (IRS issues, trouble verifying 1099s, etc.). So, if there’s lots of paperwork between preapproval and final approval, is there a way your lender could take care of that stuff before you make the offer? Enter the glorious credit approval.
Get a full “credit approval”
As Mark puts it, credit approval is when your lender goes a step beyond preapproval and thoroughly verifies your assets, income, credit, and employment. They do 99% of the paperwork for the final approval before you even submit the offer. This makes it much safer for you to remove your financing contingency and accelerates your time-to-close, making your offer significantly more appealing to sellers. However, credit approvals are risky for lenders; they take time and money, both of which they may never recoup if the buyer never actually buys a house. That’s why lenders typically only do full credit approvals on the most qualified clients they know are serious. You can increase your chances that your lender will do a full credit approval for you if you:
- Work with a small local lender (not a big, busy bank).
- Have excellent credit.
- Put 20% down.
- Build trust and rapport with your lender by submitting paperwork on time, avoiding human error, etc.
As a next step, you can ask your real estate agent if they know a good local lender who would consider doing a full credit approval on someone with your buyer profile.
A financing contingency grants you, the buyer, a backdoor out of the contract if your mortgage financing falls through. Without one, you can still back out, but you’ll have to leave your earnest cash on the table and, in rare cases, risk getting sued by the seller. Thankfully, it’s also one of the safer real estate contingencies to remove from a home offer under the right circumstances. If you can get full credit approval from your lender, you can waive your financial contingency, close faster, and overall dazzle sellers in a challenging market.