Generally, all purchasers of a cooperative or condominium apartments or a house need to obtain a loan to conclude their purchase. In such cases, to protect the purchaser, the contract should contain a clause called the “finance contingency” clause. This provision stipulates that in the event the purchaser does not obtain a written loan commitment from a lender within a certain time period, the purchaser or the seller have the right to cancel the contract with a refund of the down payment. This article will explore the issues for both purchasers and sellers in connection with the finance contingency clause.
What Is A Financing Contingency?
A “finance contingency” (also known as a mortgage contingency) is a condition in a contract of sale that entitles the purchaser to cancel the transaction and receive a refund of the down payment if he or she cannot secure a loan. Since a finance contingency gives the right to a buyer to terminate the purchase, a seller should determine if the buyer has the financial capacity to secure a loan. Generally, the purchaser has a certain period of time after the contract is signed (usually 30 days) to obtain a loan commitment letter from a lender. If after a good faith effort the purchaser cannot secure a loan within the agreed upon time period, the purchaser or the seller can cancel the contract and the down payment is returned.
Contract of Sale Provisions Regarding Financing.
For Co-ops and Condo apartment sales, the accepted practice in the real estate industry is to use the form of contract of sale prepared by the Real Property Section of the New York State Bar Association and the Committee on Real Property Law and the Committee on Cooperatives and Condominium Law of the Association of the Bar of the City of New York. For a 1 to 4 family house, the form contract is prepared by the Real Property Section of the New York State Bar Association, the New York State Land Title Association, the Committee on Real Property Law of the Association of the Bar of the City of New York. Each form contains, a clause providing that the purchaser or seller has the right to cancel the contract if the purchaser does not obtain a written loan commitment in a specified period of time. The financing contingency clause, in substance, contains the following obligations:
- The purchaser must apply for a loan within seven (business) days after the contract is fully executed by both parties and returned to the purchaser.
- The clause will indicate what type of loan the purchaser is attempting to obtain (eg. a 30- year fixed rate loan at the prevailing rate of interest).
- The clause will provide how much money the purchaser wants to borrow.
- The purchaser must provide any and all documents requested by the lender in order to obtain a loan commitment letter.
- The purchaser is given a certain period of time, typically between 30 to 45 days, to secure a written loan commitment letter (this time period is determined when the contract is negotiated).
- In the event the purchaser is unable to obtain a written loan commitment within the stated time period, either the seller or the purchaser can cancel the contract upon written notice, and the down payment must be refunded.
- If the purchaser or his or her attorney does not notify the seller or the seller’s attorney that the purchaser has not been able to secure a written loan commitment within the stated time period, the contract provides that the purchaser has waived his or her right to cancel the contract and must continue to proceed to closing, or the purchaser shall forfeit the down payment.
The form contract defines a “loan commitment letter” as a written offer to make a loan to the purchaser contingent upon a satisfactory appraisal. If the appraisal equals or exceeds the purchase price, the purchaser must proceed with the transaction. If the appraisal comes in below the sales price, the purchaser may have the opportunity to cancel the contract because the lender will not make a loan in the amount applied for by the purchaser.
The form contract also provides that the purchaser must apply to a “lending institution,” which is a bank, savings bank, savings and loan association, trust company, credit union of which purchaser is a member, insurance company or government entity. If the borrower is applying for a loan through a mortgage broker, it is imperative that the purchaser’s attorney modify the contract to contain this revision.
Even if the purchaser appears to have a respectable financial statement, the seller should ask to receive a “pre-approval” letter from a lender or mortgage broker. The purchaser should always arrange to meet with a lender or mortgage broker prior to signing a contract to determine if they will qualify for a loan in the amount that they want to borrow. It will be a waste of time for everyone involved, including the purchaser, if the purchaser does not qualify for a loan alter the contract is negotiated and signed. A pre-approval letter merely states that the lender or mortgage broker has pre-qualified the purchaser for a loan in a certain amount. While a pre-approval letter is not a loan commitment letter, which requires a full underwriting review by the lender, the pre-approval letter, which can be obtained in as little as one day, can give the seller some peace of mind with respect to the purchaser’s ability to secure a written loan commitment letter. A pre-approval letter does not include a credit report of the purchaser. If the purchaser has a questionable credit history, the loan may be denied even though the purchaser has a substantial income and assets.It is important for a purchaser to understand that because they “pre-qualify” for a loan doesn’t automatically mean that they will get a loan. Generally, a lender will focus on 3 primary areas when making a co-op or condo loan to a purchaser:
- Borrower qualification
- Building approval (if a co-op or condo)
- Acceptable appraisal of the home
Many purchasers do not realize that a lender’s determination to make a loan will be based on two primary concerns: (1) The purchaser’s assets, liabilities, assets, income and credit; (2) the building’s financial condition or (3) the appraisal. While many purchasers may have the financial wherewithal to obtain the loan, if the building does not meet with the lender’s approval, the loan can be rejected. A purchaser who has not had a lender check the status of a co-op in advance can result in the declination of a loan.
Many purchasers will qualify for a loan but if the building does not meet the lender requirements or the appraisal comes in low, then the loan can be rejected. It is a false sense of security when a purchaser gets pre-approved. Many borrowers think if they are pre-approved the lender will make the loan. However, if the lender is not satisfied with the building, the lender can reject the loan even if the borrower is overqualified.
Sale of Current Property as a Condition.
Furthermore, if the purchaser must sell another home or apartment, the purchaser’s’ commitment letter may provide that the purchaser must be under contract to sell or have closed on the sale of their current residence. The purchaser may not be able to conclude the purchase of the apartment because he or she has not sold their current residence. The seller should inquire as to this matter. Customarily, the seller’s attorney inserts a clause in the contract that provides that the contract is not contingent on the sale of any property that the purchaser currently owns.
Waiving The Finance Contingency.
In an aggressive seller’s market, in order to stay competitive, the purchaser may have to waive the finance contingency. When an offer is accepted in which the Purchaser waives the finance contingency clause, the risk shifts from the seller to the purchaser. The clause is deleted from the contract in its entirety and if the purchaser does not secure a loan, the purchaser will need to find alternative financing very quickly or possibly lose his or her down payment. Waiving the finance contingency when a purchaser needs a loan to conclude the transaction is an extremely risky decision. Because of the aggressive market, many purchasers agree to eliminate the finance contingency clause in the contract to make the deal. When the finance contingency clause is deleted from a condominium or residential home contract, it eliminates any conditions to the transaction (other than the requirement of the seller to deliver unencumbered title to the premises)..Elimination of the finance contingency clause in a co-op contract still leaves one condition that needs to be satisfied: co-op board approval of the transaction. If the purchaser waives this condition and does not secure a loan, the purchaser will still be contractually obligated to purchase the home and if the transaction cannot be concluded because the purchaser has not secured a loan, the down payment may be forfeited to the seller. For the seller, waiving the finance contingency is beneficial because it removes a condition so that the purchaser can back out of the transaction.
When a purchaser agrees to waive the contingency and in order to reduce the risk of not being able to secure a loan, the purchaser should take 4 steps:
- Obtain pre-approval letter from a lender reflecting that the purchaser is pre-approved for the loan.
- See if the lender has approved the building and has made loans in the building in the past.
- Run a credit report to see if there is any adverse credit issues against the purchasers.
- Have the purchaser’s attorney complete a thorough due diligence review of the building to see if the building meets the new lender requires (see below).
What Satisfies The Mortgage Contingency (What is a Conditional Commitment)?
The standard contract of sale provides that upon the issuance of a commitment letter, the financing contingency is satisfied and the condition is removed. A finance contingency is not satisfied if the loan commitment letter is conditioned upon an appraisal that is satisfactory to the lender. Accordingly, if the lender issues a loan commitment letter and the appraisal has not been completed by the time the commitment letter is received, the loan does not become firm until the appraisal is acceptable to the lender.
The co-op contract expands on the finance contingency: The purchaser can terminate the contract if any requirement of the commitment letter (other than one concerning the purchaser) is not met. For example, if the commitment letter is issued and contains a provision that the lender must be satisfied with the building’s financial condition or owner occupancy quota, and determines that these requirements do not meet the lender’s underwriting condition, the purchaser can cancel the contract and receive a refund of the down payment. If however, after the commitment letter is issued and the bank learns that the purchaser has changed jobs for a lower salary and withdraws the commitment, the purchaser cannot claim that the finance contingency has not been met.
This expanded language however does not currently appear in the Condominium contract.
Another issue, but not quite as risky as when lenders were in financial trouble in 2008, is if the commitment is issued and the lender fails to fund or withdraws the loan. While many purchaser’s attorneys for purchasers request a “funding” condition in a contract, it is unlikely that such a clause may be acceptable by the seller. The addition of a funding contingency increases the condition to an even greater degree providing even more protection to a purchaser.
To be safe and reduce any condition about the lender being able to back out of the transaction, purchasers should request an “unconditional” commitment. The unconditional commitment will mean that the lender is satisfied with the financial condition and credit of the purchaser, the financial condition of the building as well as the property appraisal.
Understanding the Differences in Financing Contingency Clauses in a 1 to 4 Family House and Condominium Contract vs a Co-op Contract. There are significant differences between the co-op contract and the condominium/1 to 4 family house contracts regarding financing contingencies:
A. 1 to 4 Family House and Condominium Contract – The printed language in the condominium and 1 to 4 family house form of Contract of Sale includes a mortgage or finance contingency provision. Generally, if the time period to secure a commitment letter expires, the purchaser has the option to request more time to secure the commitment or terminate the contract. If the seller will not agree to the extension, the seller can terminate the contract and the down payment should be refunded to the purchaser. If the purchaser fails to request an extension of time or does not secure a commitment and does not request the termination of the contract, the purchaser is deemed to have waived the right to terminate and may be stuck with proceeding without a loan.
B. Cooperative Apartment Contract – The latest form of co-op contract of sale requires the selection of one of 3 provisions:
- The contract is conditioned upon the purchaser obtaining a written loan commitment.
- The contract is all cash and the purchaser shall not seek any financing (i.e. the purchaser is prohibited from applying for a loan)
- The contract is not conditioned upon the purchaser obtaining financing but the purchaser will be seeking financing.
The last alternative has created some difficulty and gray areas of interpretation. The question becomes what happens if the purchaser waives the finance contingency, needs but does not secure financing, submits his or her co-op board application and is denied by the co-op. Technically, the contract provides that if the co-op denies the purchaser’s application, then he or she can cancel the contract and receive the down payment. However, if the board denial is due to the fact that the purchaser did not have sufficient funds to purchase the apartment because he/she did not get a loan, then waiving the financing contingency is useless.
Sometimes the Seller’s contract rider will contain a clause that if the purchaser does not secure a mortgage when the financing contingency is waived, that the purchaser will proceed with the transaction all cash. Alternatively, the contract may provide that if the board denies the purchaser because he or she failed to secure a loan and the board denial can clearly be established because of insufficient purchase price proceeds, it is a material default and the purchaser may forfeit the down payment.
If the contract is contingent upon financing, the purchaser may have the right to terminate the contract and receive the refund of the down payment if the apartment does not appraise at the amount of the sales price. If the apartment appraisal comes in lower than the sales price, the seller can offer to reduce the sales price to that of the appraisal to try to conclude the transaction. If the purchaser and seller agree to lower the sales price, the purchaser will also have to agree to accept a lower loan amount.
However, if the transaction is contingent upon financing and the premises do not appraise out, the purchaser must still proceed with the transaction with the lower loan amount and will not have an opportunity to negotiate the sales price. For example, a purchaser enters into a contract to buy an apartment not contingent upon financing for $200,000. The purchaser, however, needs a loan of $160,000 to conclude the transaction. If the appraisal of the apartment comes in at $180,000, the maximum amount the lender may loan to the purchaser may only be $144,000 (ie. 80 percent of $180,000, assuming the building allows 80 percent financing). If the foregoing example was contingent upon the purchaser obtaining a loan in the amount of $160,000 and the apartment appraises at $180,000, the seller and purchaser must either agree to lower the sale price to $180,000 or the purchaser has the right cancel the transaction (unless, of course, the purchaser agrees to purchase the apartment at $200,000 with a loan of $144,000).
New Lender Requirements.
The sub-prime mortgage debacle in 2008 forced many lenders to seriously change their underwriting requirements and procedures. These new changes include, among other things, the following concerns:
- On new construction, buildings must have a certain percentage of the units sold if the lender will make a loan
- Co-op/Condo Questionnaires must be completed quickly and provided to the lender for analysis. This process can take as long as 4 weeks.
- Appraisals cannot be done before a contract is signed. The process can take 3 weeks.
- Lenders look at co-op and condo financial statements carefully to determine surplus and deficits and the amount in reserves.
- Insurance certificates must show additional errors and omissions and fidelity coverage (could take months to have increased by co-op/condo).
- If the building has 10 units are less or the building has made loans to 25% or more of the current owners in the building, the lender may not make a loan.
- The building reserve fund must be at least 10%.
A lender will review the following issues in evaluating whether to finance a loan for the purchase of a co-op apartment:
- How many units are sponsor owned. If the sponsor owns more than 50 percent of the units in the building, the lender may not make a loan);
- How many units are owner occupied;
- Whether the building operates with an annual positive cash flow (i.e. the income the building receives must exceed the operating expenses of the building);
- The size of the apartment (if the apartment is less than 600 square feet, the lender may not make the loan);
- The building must contain a minimum of 10 apartments;
- The lender has not already financed more than 25 percent of the units in the building;
- The amount of the underlying mortgage on the building cannot exceed a certain percentage allocated to the apartment (known as the “pro-rata share”).
If these issues-do exist, it does not mean that the purchaser cannot obtain a loan. It may only mean that the purchaser will not obtain a competitive loan.
- Appraisals. Depending upon the market, appraisals are not able to keep up with rapidly increasing sales prices. If an appraiser looks at comparable units and the last sales were 6 months to a year ago, the appraised value may be lower than the purchase price which would may reduce the loan amount.
- Commitment Expiration Dates. Every commitment letter expires after some time (usually 60 to 90 days after issued). Please be mindful of this if the close date is in excess of 60 days. If the commitment expires, it is generally not difficult to obtain an extension. However, if an interest rate is locked in at the time of the commitment, it is much harder to extend the rate lock if the commitment expires (it usually can be extended provided costly extension fees are paid to the lender).
- Rate Lock Expiration Dates. Many purchasers who are concerned about rising interest rates may lock the interest rate usually for a period of 60 days. It is conceivable that an interest rate lock in may expire while the transaction is pending. In a house or condominium sale, the purchaser takes the risk of losing the rate lock in if the transaction cannot close before the rate lock expires. However, in the standard form co-op contract, if the closing is delayed through no fault of the purchaser, the ________. In finance contingency contract, it is always a good idea to include a provision that the seller will close before the expiration of the commitment letter and rate lock, if possible.
- Change of Underwriting Policies. A loan commitment letter can be withdrawn if Fannie Mae requirements change. While this does not happen often, it is possible.
- Finance Limitations. The purchaser should not apply for more that the amount set forth in the contract. If he or she does and is denied the loan, the seller may claim that the purchaser did not comply with the contract and may attempt to keep the down payment. In addition, all purchasers of co-op apartments must be made aware of the finance limitations imposed by the co-op. For example, if the co-op only allows 75% financing, the purchaser should not apply for more even if the transaction is not contingent upon financing.
- Seller Termination. If the purchaser is unable to secure financing within the time period set forth in the contract, it is possible for the seller to terminate the contract and refund the down payment if the seller has a substitute ready willing and able purchaser who can purchase the property all cash or at a higher purchase price.
- Bad Faith. As a note, the form contract of sale provides that the purchaser must act in good faith when applying for and securing a loan commitment letter. If the purchaser is unsuccessful in securing a loan due to bad faith, the seller may hold the purchaser in default and keep the down payment. Therefore, a purchaser cannot intentionally try to terminate the transaction by falsifying information on the loan application. If indeed the purchaser has been denied a loan, a copy of the loan declination letter as well as the purchaser’s loan applications should be submitted to the seller’s attorney when terminating the contract and requesting a refund of the down payment.
As outlined above, the purchaser and seller both must be aware of the issues involved with the finance contingency clause in the contract of sale. A failure to understand the issues raised in this article can only result in hard work by both seller’s and purchaser’s attorneys and the mortgage broker without a concluded transaction.
*DISCLAIMER. Nothing herein is offered as legal advice. All information in this article is for informational purposes only. Please consult with an attorney before taking any legal actions.