Buyers who require financing can improve their chances to compete with cash buyers by waiving the mortgage contingency. Most of my deals over the past few years have been cash or non-contingent. An increasing number of my deals today are contingent, but it is still a minority. This blog post discusses a bit about the mortgage contingency, what it means to waive it and the ramifications, and how to best protect yourself if you decide that you have to waive it to give yourself the best chance in a competitive bidding.
The mortgage contingency is a provision in the standard purchase and sale agreement that allows a buyer to cancel a contract and get her deposit back if she cannot obtain a loan commitment for a specific loan amount specified in the contract within a set period of time – typically 30 or 45 days after a fully executed contract is delivered to the buyer and the deposit is received by the escrow agent. Buyers are obligated to use good faith efforts and to act promptly to obtain their loan commitment. Once the buyer receives a loan commitment for the amount of financing set forth in the contract, the mortgage contingency provision is satisfied and the buyer can no longer cancel the contract and receive their deposit back under that provision, even if the lender refuses to fund the loan at closing.
In order to satisfy the mortgage contingency provision, the loan commitment must be for an amount at least equal to the loan amount set forth in the contract. For example, if the contract is to purchase a unit for $1,000,000 contingent on 80% financing, the mortgage contingency will not be satisfied unless a loan commitment is issued for $800,000. This can be problematic in cases where the property is appraised by the bank at a price lower than the contract price because the bank will only lend against the appraised value of the unit. Thus, if the purchase price is $1,000,000, but it only appraises at $950,000, and the bank will not give you a loan commitment for more than 80% of the appraised value, you will not technically satisfy the mortgage contingency and can cancel the contract. Thus, a key portion of the mortgage contingency is an appraisal contingency, because if the unit does not appraise, you will be able to exercise your rights under that provision.
If a buyer does not waive the mortgage contingency, and the loan commitment is not procured during mortgage contingency period, she has to either (i) extend the mortgage contingency period, or (ii) cancel the contract prior to expiration of the mortgage contingency period. If the buyer does not take either of those actions, the mortgage contingency period will expire and the buyer will be deemed to have waived the mortgage contingency.
So…what does it mean to waive the mortgage contingency?
When a buyer waives the mortgage contingency, she is agreeing that she will purchase the unit whether or not she can get a loan, or more accurately, a loan commitment. If the mortgage contingency is waived from the outset or deemed waived due to the expiration of the contingency period, and the buyer cannot purchase the home pursuant to the terms of the contract, then she will default under the contract. The only remedy that a seller has against a buyer who defaults under a real estate contract is to take the buyer’s contract deposit, which is typically 10% of the purchase price in most NYC deals. This is a very punitive remedy for a buyer, given the extraordinary price of NYC real estate, and a serious risk that should not be taken lightly.
Practically speaking, this probably does not happen too often because what buyer will allow the forfeiture and seizure of a huge amount of money so easily? Nobody. In my career as a broker, many of my clients have waived the mortgage contingency or allowed the contingency period to lapse, and only one of them has failed to procure a loan commitment when one was needed. This particular client’s loan application was denied for reasons beyond his control, and he was able to negotiate a release from the contract for a payment of approximately 7.5% of the deposit, which was mostly to compensate the seller for work done during the contract period at the buyer’s request. If the seller had not spent any money during the contract period, I doubt the release would have cost my client as much as it did. If the seller does not agree to reduce the penalty and tries to seize the entire deposit, a buyer will likely sue the seller to enjoin such an action under the contract, and the dispute will likely be handled by a court, which could take a long time, cost a lot of money, and is not a desirable outcome for either the buyer or seller.
So…you find an apartment you love, but are bidding against a cash buyer and want to waive the mortgage contingency to give you the best shot at winning the apartment, how can you protect yourself?
First, you should talk to your mortgage professional. By the time you are considering waiving the mortgage contingency, you should already have a mortgage pre-approval letter, so your mortgage professional should have received all the documentation necessary to have preliminarily approved you as a borrower for a certain loan amount. Ask your mortgage professional two questions: (i) will I be approved as a borrower, and (ii) is this building approved. Your mortgage professional should be able to tell you, with relative certainty, whether or not you will be approved by the bank’s underwriters for the size loan you will need. The building’s approval will be less certain. The City’s largest mortgage lenders – Wells Fargo, Citibank and Chase – have tons of buildings approved, so it may be relatively easy to confirm that the bank is willing to lend in a building. If the building is not approved, it is important to have your mortgage professional work quickly to get the building approved. Your lender should be able to tell you whether the building is or will be approved for lending prior to you signing a contract.
Second, you should understand the risk of a low appraisal. Since you are bidding on a particular unit, your broker should have already advised you on the unit’s market value. But appraisal risk is something different. In a rising market, which many Manhattan and Brooklyn neighborhoods have experienced over the past few years, a unit’s market value can sometimes differ from an appraiser’s valuation. It is important to have a conversation with your broker to estimate the risk of a low appraisal and what that might look at, based on objective criteria. With that information, you should be able to get reasonably comfortable with how much additional funds you might have to come out of pocket for at closing to cover the gap between the purchase price and the loan amount (which will be based on the appraised value).
Third, you should talk to your lawyer about the mortgage contingency provision to understand exactly what it says, what it means, what each party’s obligations are and what the risks are.
There are different strategies to dealing with the mortgage contingency, as well. You can divide the mortgage contingency into a few different parts to assume some of the risk that you can best understand. For example, if you are confident in your ability to get a loan, and have significant reserves in the event of a low appraisal (or are planning on financing an amount that would render a low appraisal irrelevant – typically 75% or less), you can waive the mortgage contingency as to you, as a borrower, and assume the risk of a low appraisal, but preserve the mortgage contingency as it relates to the building if your lender cannot approve the building before you have to sign the contract.
In today’s lending environment, if you are a strong borrower with great credit and adequate assets and income relative to your debts and the loan you need, it is highly unlikely that you will not get the loan. But still, even though waiving the mortgage contingency does increase your competitiveness relative to cash buyers, if the seller wants to sell quickly, it will unlikely be enough to prevail, all else being equal.
Digs Realty is a full-service residential real estate brokerage company specializing in home purchases and sales in New York City. Clients working with Digs on a purchase are eligible for a rebate of up to 2% of the purchase price, and clients working with Digs on a sale are eligible for commission discounts.