Financing Contingency 101

The financing contingency is one of the most often misunderstood parts of a residential transaction. There is plenty of confusion regarding who it protects and how, what requirements it creates, and what triggers its protection. If you zoom out, though, it helps clarify what’s going on here.

Imagine a home buyer and home seller having a conversation. The Buyer would like to buy from the Seller, but needs a certain amount of time to gather the funds to do so. The Buyer wants the Seller to stop taking offers from other potential buyers, and commit to selling it to the Buyer once they have the money. The Seller might be willing to do this, but they are going to want some kind of security or assurance from the Buyer that the sale is going to actually occur. So we have a wonderful solution where the Buyer pays a little toward the purchase now, and will pay the rest later. This is the “earnest money” deposit, which is a significant chunk of cash. The deal is, if the Buyer doesn’t come up with the rest of the cash later, the Seller keeps the deposit and can sell to someone else.

Okay, now let’s assume the Buyer is getting the rest of the cash from a third party, a mortgage lender. The lender is going to take a mortgage on the property as security for their loan, so they really want to make sure the Buyer can afford to pay them back, and also that the property is worth what the Buyer is paying for it, in case they end up having to foreclose.

That second part understandably makes the Buyer uncomfortable, since Buyer doesn’t have any control over whether the Lender is going to approve the loan. So, the Buyer goes back to the Seller and says, if the Lender doesn’t approve this loan, I should get my money back. After all, the Buyer doesn’t really have any control over this, so it makes sense they wouldn’t want to risk their money on someone else’s determination.

The Seller is rightly bummed out by this, but since most buyers are going to make the same request, they’re willing to work with the Buyer on it. However, they don’t want to be stuck waiting indefinitely for the lender to make their decision – they want the certainty that they are going to close, and soon. So: we come up with a date, usually a couple weeks before the closing, where the Buyer can’t get their money back anymore, even if they lender doesn’t give them the loan.

Now we have this two-week period where the Buyer has all this risk of the Lender dropping the ball. Once the deadline passes, if the lender doesn’t come up with the money, the Buyer won’t have the cash and their deposit will be kept by the Seller. Now it’s the Buyer who needs some kind of assurance from the Lender before they’re comfortable moving forward. Enter the financing commitment – this is a letter from the Lender saying that they are committed to giving the Buyer the money by the closing date. This makes the Buyer feel better about letting the deadline go by; the commitment letter shifts the risk to the lender, who has satisfied itself that the Buyer is creditworthy and the property is sufficiently valuable.

Now, back to real life, all of this is baked into the original offer the Buyer makes to the Seller, with the guidance of their Buyer’s agent and attorney, to make sure the language in the contingency protects their deposit.