Okay, so if you’re like most people, you probably haven’t spent much time reading over real estate contracts lately. Contracts which, over the past 20 years, have grown from two pages to eight, not to mention supporting addenda and disclosures. Simply making an offer on a property now consists of 25 or more pages of documents and a dozen signatures. As a prospective homebuyer, unless you purchase a home every couple of months, you are largely dependent on your buyer agent to walk and talk you through this pile of paperwork.
One important aspect of any purchase contract is the financing contingency.
Now, if you are fortunate enough to be able to pay cash for your next home, I won’t be offended in the least if you skip the rest of this article and go back to counting your vast fortune (I’m just kidding… unless that’s really what you do). But for the rest of us, structuring this contingency to properly protect you is paramount.
The 4 Elements of a Financing Contingency
The financing contingency contains several key components the buyer has the option to specify: the type of loan the buyers intend to obtain; the down payment the buyers intend to make; the maximum interest rate the buyers would accept; the amortization of the loan and the discount/origination points required to obtain that loan. I often tell buyers they are “drawing a box” and requiring all aspects of the loan they obtain to fit within that box. All the criteria must be met (or exceeded) in order for the contingency to be satisfied.
1) The Type of Loan
So, first off, what type of loan? Many first time homebuyers will use FHA financing; purchasers with limited down payment funds often choose USDA (or VA if they qualify) loans; purchasers with more money for a down payment may prefer Conventional financing. Step one is choosing the type of financing most suited to the buyers and their situation. For this reason, it is highly recommended that a buyer first talk with a lender to work through the many options available. Once a lender reviews the buyer’s debt, income, savings and credit, that lender can then direct the buyer to the best loan products for their given scenario.
2) The Amount Financed
Okay, so after choosing the loan, the next decision is how much of the purchase price will be financed by that loan. Put another way, how much of a down payment will the buyers make? Let’s say the Roberts family is buying a home for $200,000, and they have $10,000 to use as a down payment. That would equal a 5% down payment, leaving 95% of the purchase price to be financed (or secured by a loan).
3) The Interest Rate
The next decision for a purchaser is the maximum interest rate they would accept. Again, very important for the buyers to have some idea of the rate they might receive from a lender. The thinking here is that a buyer does not want to be required to make good on their purchase if the only rate they can qualify for is exorbitant or unaffordable. Using the Roberts as an example again—let’s say that between the time they make their offer, and the time they sit down to actually apply for a loan, something catastrophic happens either to them personally or on a national/global scale. The end result is that their interest rate goes from, say 4%, up to 5% or higher. This increase could potentially make the expense of owning this new home a financial burden too great to bear.
Most buyers look at the interest rate given to them by their lender and think, “Well, if it goes up 1/4 or even 1/2 of a point, that’s not going to kill me; but if it were to increase by more than that, I’m not sure I’d want to buy this house.” Every buyer and every scenario is different; the main point is to protect yourself by indicating some interest rate as the maximum acceptable to the buyers.
4) The Life of the Loan
And, lastly, it’s wise to indicate if the buyers intend to apply for 30-year or 15-year loan and to specify how many (if any) points the buyer is willing to pay to qualify.
Taken all together, these four decisions create the “box” in which the buyer’s loan must fit. And, again, once determined, the buyer is free to accept financing that exceeds their criteria, meaning they can get a better rate, make more of a down payment or choose a shorter term of amortization.
Hopefully this helps provide a basic understanding of the aspects included in a financing contingency and prepares you for making some of those determinations before you sit down to write up your next offer. Good luck!
By Dan Vollmer