When you’re getting ready to buy a New York City apartment, one of the most important offer terms is a financing contingency. Learn what it is, how it protects you and if you should ask for one.
What is a financing contingency?
Does a financing contingency eliminate mortgage risk?
Why wouldn’t you ask for a financing contingency?
Why appraisals are often a sticking point
What to do if the seller won’t agree to a financing contingency
What are the risks of not having a financing contingency?
Financing contingencies on new development
What is a financing contingency?
A financing contingency or mortgage contingency protects the buyer from losing their deposit if they cannot get a loan. It is the most common form of contingency in NYC and written into the purchase contract. If a financing contingency is exercised, the buyer cancels the contract and their deposit is returned.
Requests for a financing contingency should be made with your original offer as it is a deal term that will be considered by the seller. If you try to add a financing contingency later on, the seller will likely say no.
Does a financing contingency eliminate mortgage risk?
No. In NYC, a financing contingency only protects the buyer until they receive a commitment letter which is about 30 days after signing the contract. Given it takes 60-90 days to close, that still leaves time for things to go wrong.
When you receive the commitment letter, it will contain contingencies with the gist of nothing bad can happen before closing. For example, you can’t lose your job. If you do, your lender will not make the loan. Each contingency will be explicitly listed in the commitment letter.
The only exception is a low appraisal. Sometimes lenders will complete their underwriting prior to the appraisal and issue a commitment letter pending that piece of information. Most financing contingencies require an appraisal be completed before it is satisfied.
A financing contingency is still very valuable though. In order to receive a commitment letter, your lender will complete a thorough underwriting of your financials as well as the building’s financials. A financing contingency protects you from any surprises from the building and any earlier misunderstandings between you and your bank. You'll also have a way out if the appraisal comes in low.
Buyers often get a financing contingency confused with a funding contingency. A funding contingency is more comprehensive and allows the buyer to cancel the contract if they cannot get the money to close for any reason. They are extremely rare in NYC.
Why wouldn’t you ask for a financing contingency?
Sellers don't like financing contingencies because they give the buyer a way out. No seller wants to go through the time and expense of signing a contract and taking the property off market only to start over a month later so all else equal, a seller will choose an offer without a financing contingency.
This is similar to why sellers prefer cash buyers. A loan adds complexity and risk.
We estimate a financing contingency costs around 1%. For example, if you offer $800,000 with a financing contingency and another buyer offers $792,000 without one, the seller may opt for that to be sure the deal goes through.
Why appraisals are often a sticking point
An appraisal is a third party's estimate for the value of the property you're buying. To understand how it can derail a mortgage, it’s helpful to run through an example.
Say you are buying an apartment for $1,000,000 and your bank's max loan to value (LTV) is 80%. In other words, they require 20% down. The financing contingency will say the you can cancel the contract if you can't get a loan for $800,000.
But then there’s a problem - the appraisal comes in at $950,000. The bank doesn’t care how much you’re paying. As far as they’re concerned, the apartment is worth $950,000. Since their max LTV is 80%, they will only give you a loan for $760,000 (80% of $950,000). That's $40,000 less than you need so the financing contingency kicks in and you can cancel the contract.
You can cancel but you don't have to. As the buyer, you’re in control. If you have another $40,000, you can choose to move forward but usually in exchange for a lower price.
This free option is often why sellers will push back on the appraisal contingency that's baked into the financing contginency. An appraisal is simply one person's opinion on a given day so they can vary widely. Also it's a one way option - if it comes in high, the seller can’t try to raise the price.
What to do if the seller won’t agree to a financing contingency
Especially if there are multiple buyers, sellers will sometimes turn down financing contingencies. It would be easy to assume there is no deal if you are firm on getting one and the seller is firm on rejecting one. However there is a compromise that sometimes gets the job done.
If you offer to make a larger down payment, should it be necessary, it basically eliminates the unpredictable appraisal from the contingency.
In the example above, you can say you want to put down 20% but if the appraisal comes in low, you’ll put down up to 30% or $300,000. Since you can still get a loan for $760,000, there is no problem.
If you lose your job or the world falls apart, you’ll still be protected. Sellers understand those concerns and are less likely to push back.
What are the risks of not having a financing contingency?
There are three main risks involved with not having a financing contingency -
- Your Financials - Make sure you share everything with your lender before signing the contract so there are no surprises.
- The Building - In addition to underwriting your financials, the lender is also underwriting the building. They may have a problem with an imbalanced budget or pending litigation. To minimize this risk, see if your lender has approved the building. You can also see which lenders have recently made loans in the building. Let us know if you’d like help with that.
- A Low Appraisal - As mentioned above, if the appraisal comes in low, you’ll have to increase your down payment.
You should always discuss with your attorney, lender and agent to make sure you understand these risks and any others and are 100% comfortable with them.
Financing contingencies on new development
Getting a financing contingency in a new development is tricky because of the timeline. If you receive your commitment letter in a month and deliveries aren't expected until next year, that leaves a lot of time for something to go wrong. For this reason, new developments often do not agree to financing contingencies.
If you are focused on new development but also want a financing contingency, your best bet is to focus on buildings that are completed or close to it. Timelines will be shorter and therefore less risky.
You can also ask for a funding contingency but even in a weak market, sponsors rarely agree to them.
This post is for informational purposes and should not be used as legal advice. Please speak to your attorney to review your particular transaction and situation.
