What Is a Loan Contingency?

Contracts for purchasing a home commonly include a loan contingency clause. The clause specifies certain requirements and conditions that must be met for the buyer to proceed with the sale. Contingencies allow you to walk away from an agreement without penalty. If you put down an earnest deposit when you submit your offer, the contingency clause can entitle you to a full refund upon contract cancellation.

Tip

A contingency attached to a loan allows for adding additional requirements to be met that aren't traditionally stated within the general loan contract.

How Contingencies Work

Mortgage approval is based on many factors. The purchase offer you submit on a home becomes a legally binding contract, if accepted. If you back out, the seller can charge you with a breach of contract. Any contingencies in the contract, however, cover you and protect your deposit if something goes wrong with the deal. Contingencies written into a contract must specify how a contingency will be satisfied or released.

Loan Contingencies

The standard loan contingency is one that states that you, as the buyer, are not bound to the contract if you fail to obtain approval for financing by a certain date. When you are pre-approved for a mortgage, the lender has qualified you for the loan based on your credit report, debt-to-income ratio and analysis of your financial situation. Major changes to your credit, debt or assets after pre-approval can jeopardize your chances of getting the mortgage. The house must also meet certain requirements before the mortgage loan is approved. Lenders require a satisfactory search of the title record and an acceptable appraisal of the property before extending a loan. If you try in earnest but the conditions are not satisfied, the deposit is usually refunded and the house goes back on the market.

Passive Removal

A passive contingency removal requires a buyer to invoke the clause within a certain period of time to terminate the contract. If the deadline comes and goes and you have not canceled the agreement, the contingency is automatically removed — and without the contingency, you are bound to the purchase agreement. For example, a passive contingency may state you will notify the seller if you have not obtained financing 25 days before the scheduled closing date. If you cannot gain approval and fail to let the seller know in time, you can no longer cancel the sale without penalty. Although you cannot be forced to buy the home if you have no financing, you will typically forfeit your earnest money deposit. When the passive removal method is used, silence means acceptance.

Active Removal

Active contingencies remain in force until removed. If an active contingency deadline passes, and the buyer has not released the contingency, it stays in place. For example, if a contact gives the buyer 17 days to remove an appraisal contingency, the contingency stays active even after Day 17 has passed. Although the seller can require the buyer to respond as to whether he's obtained financing, the seller is unable to force the buyer to close escrow or keep the deposit. Although the active method of contingency removal requires more paperwork, it helps provide clarity and ensures buyer protection.

Contingencies in a Seller's Market

Contingencies can become a problem in a seller's market, especially in a situation where every home has multiple offers within hours of being put up for sale. In those situations, buyers may find that they consistency lose houses to buyers who don't require essentials like home inspections. You have several options in this instance. One is to pay for an inspection out of pocket before making an offer. You can also schedule an inspection for a day or two after putting the contract in and include that information in the contract. This will let the seller know that if an issue is found, they'll at least know quickly, rather than waiting weeks for an inspection, only to have the deal fall through.