[Editor's Note: This is a guest post from Eris Saari, President of AmeriFund Home Mortgage, LLC based out of New Jersey. He has been doing residential mortgage lending for 25 years. We have no financial relationship.]
Let’s say you’ve started looking for a home. At some point, your realtor may say, “If you really want the house, you should make an all cash offer!” What does that mean – you come to the closing with a giant stack of bills? You tap the trust fund and write a big check? No – it means you waive your mortgage contingency.
An All Cash Offer Eliminates a Mortgage Contingency
What is a mortgage contingency?It is a clause in your contract that protects your hard earned money. When you sign a contract to buy a house, you typically put down 10% of the purchase price. [Maybe it's different in NJ, but in most deals I've seen, you put some earnest money into escrow, sometimes as little as $500.-ed] A financing contingency enables you to get your 10% down payment [or earnest money] back if you are declined for financing.
I bet you’re thinking, “I won’t be declined – I’ve already been pre-approved by several banks!” Your income is excellent; your debt-to-income ratios are well within guidelines, and your credit score is 800.
No Protection from Low Appraisal
Let’s say you want to buy a house that’s listed for $500,000. You bid the asking price; your offer is accepted. You sign a contract and put down 10% of the purchase price or $50,000. Your contract includes a mortgage contingency clause for $400,000 (80% financing).
You apply for your mortgage. Your lender orders an appraisal. The value comes in low – at $480,000. Now what happens? Technically, you would be declined for your mortgage because your financing contingency was for 80% financing (or 80% loan-to-value or LTV). But wait – the house is still selling for $500,000. You’re still borrowing $400,000. Isn’t that still 80% LTV?
No. Why not? Because banks base LTV off the lower of the purchase price or appraised value.
Your LTV is now 83.33% ($400,000 divided by $480,000). Whenever you borrow more than 80%, your loan is subject to PMI (Private Mortgage Insurance). But you didn’t apply for a loan with PMI. It wasn’t in your initial disclosures and it wasn’t in your initial loan application detailing the breakdown of your monthly mortgage payment. Therefore, the terms you applied for ($400,000 loan with no PMI) are no longer available to you, so you would be declined and if you have a mortgage contingency, you would get your down payment/earnest money back.
But what if you still want to buy the house?
You could do a couple of things: renegotiate the purchase price with the seller and get him to drop it to $480,000 (or some point in between); if the seller doesn’t budge, decide to put down more money to make your loan 80% of $480,000 or $384,000, which means you now have to come up with an extra $16,000 (for a total down payment of $116,000) or proceed with your original loan amount of $400,000 and pay the PMI. A word about PMI – in recent months, several lenders have reinstituted programs to help borrowers avoid PMI.
[My mortgage page lists many lenders and banks all over the country who offer “doctor loans” –loans which require less than 20% down and don't require PMI.-ed]
How Does an “All Cash” Offer Work When Buying a House
Now let’s see what would happen if you waived your financing contingency. Once you do that, you are saying that even if you don’t get approved for whatever reason, you are going to buy the house, and if you don't, you will forfeit your down payment/earnest money. $50,000 is a lot of money [and a ridiculously high amount of earnest money IMHO, but you don't want to lose $5000 in earnest money any more than $50,000 in earnest money-ed.] You better be very sure your loan will be approved. Even if your loan does get approved, what if something happens prior to closing that means you no longer qualify? What if you get into an accident, or your spouse loses his job? You still have to buy the house or lose your down payment. What if the house appraises $100,000 less than the asking price because of some information not known to you when you were bidding? Do you still want to buy it? If you’ve waived your contingency, you either buy it or walk away from your down payment/earnest money.
Given all that, why would anyone in their right mind waive their financing contingency? To get an edge in negotiations. Think about it – if you’re the seller with the house listed at $500,000, and you have two offers in front of you – both at the asking price – one with a financing contingency, one without — you’ll take the one without the contingency every time. Because no one wants to find out four weeks into the process that their buyer couldn’t get approved so now they have to list their house all over again. Especially if that means now you’ve missed the spring selling season and you can’t count on getting another decent offer.
Do You Get a Better Deal with an All-Cash Offer?
If a seller would always choose an all cash offer at the same price, could you, the buyer, offer a lower price and still win? What is the value of an all cash offer? Hard to say. A lot depends on the market and the specific seller’s situation. If the same seller had two offers in front of him, one for $500,000 with a mortgage contingency, and one for $475,000 with no contingency, would he take the lower offer?
Possibly. It would depend on the seller’s perception of the risk associated with a financing contingency for the higher bid. In addition, the seller might be buying a house where he (the seller) has waived his own financing contingency, so he might want a hassle free sale. However, if the seller has lined up a rental, and feels strongly he had a good house in a desirable location, he might just hold out for the highest price and not worry even if he had to put the house back on the market again.
Can You Get Down Payment Back Even if You’ve Waived the Financing Contingency?
Yes. If you are buying a co-op, you can usually get your down payment back if you get turned down by the board. Many condos now also have board approval required; the same policy would apply (but make sure your contract contains specific language to that effect). Lastly, most contracts contain language that says if the title report reveals unmarketable title, you can get your down payment back, even if you waived the mortgage contingency. [One other solution is to bail out based on “unacceptable” inspection results (you get to define unacceptable if you write the contract that way), and get your earnest money back. Of course, the financing is likely to fail AFTER the inspection contingency date.-ed]
So when you’re buying a home, think carefully about whether or not to waive the financing contingency. Make sure you are very clear on the pros and cons before you gamble with your down payment. [Also a great reason to offer a very low amount of earnest money if you're waiving the mortgage contingency, just in case. But remember that offers with low earnest money may be more unattractive than offers with a mortgage contingency-ed.]
What do you think? Would you make an “all-cash offer” in order to try to save money on the purchase or to make your offer more attractive? How much earnest money would you put at risk? Comment below!
Out here cash offers indeed mean where you write a check to the seller for the property, not re the earnest money.
The cash offer with minimal contingencies whether financing, inspection, title, that can close quickly often wins. However this means the buyer must have means to verify the above, independent of any lender.
Usually the real deals are when the seller is motivated – often death; disability/illness; debt; divorce. These sellers are looking for a quick means to relieve their burden- cash offers that close quickly, is a win win situation.
One could get some money back, by cash out refinancing.
I’d also consider the health of the HOA since they are so ubiquitous now. If the HOA doesn’t have enough in it’s “reserve fund” (usually 10-20% of the annual dues), then the bank may deny the loan. They may also look at the owner/renter ratio, or if many of the properties are owned by an investor (though this may apply more to condos). I don’t know if a buyer would lose their earnest money in a situation like this, but it’s something I’d think about before making an offer.
In a case like this, the seller may need an all cash offer. Even if I could afford it, I wouldn’t do it. I’d be worried about rising HOA fees or special assessments; and if the HOA doesn’t get its act together, I’d be locked into the property until someone else with enough cash came along to buy it.
As a side note, at least in my area, virtually all new developments are required to have an HOA. Seems like a good deal for the city, they get more tax revenue, but the HOA is responsible for maintaining the property (roads/lights/etc). It’s not surprising that reserve funds tend to be low; HOA management companies love to nickel and dime the HOA…on top of the management fee, they’ll charge you for every single page they print or fax, or for every minute of someone’s time if they go out to “look” at the property. (think of George Clooney’s boss in Intolerable Cruelty…”620 billable hours! 25 lunches charged!”) Anyway, I digress…
My experience with HOAs is similar.
People shouldn’t blindly assume that they can walk away by merely forfeiting earnest money. In most cases, the seller will elect to keep the earnest money in lieu of suing to specifically enforce the contract, but in many states (including Texas, where I live, and Utah, which I just checked), the standard real estate commission form of contract provides the seller with the option to either (i) retain the earnest money and walk away from the contract or (ii) sue to force the buyer to close the transaction (presumably with money from whatever other sources the buyer has, such as investments or cash on hand). Here is the language in the Utah form.
“If Buyer fails to comply with this contract, Buyer will be in default, and Seller may (a) enforce specific performance, seek such other relief as may be provided by law, or both, or (b) terminate this contract and receive the earnest money as liquidated damages, thereby releasing both parties from this contract.”
Although that may be the standard form, you can modify the contract in any way you see fit. No reason you couldn’t strike that out. Although the weaker you make your offer, the less likely the seller is to take it.
After our initial offer, we put in an “all cash” offer on our current home to get a leg up on another bidder. We had been renting while looking for a home for 3 years and had finally found a house that was exceptionally well-kept in this neighborhood of old homes. The asking price was fair given all the homes we had seen, so we offered asking with the standard mortgage and inspection contingency. When the second bidder came in, we were asked to put in our “best and final” offer. So we only offered 1% on top of our initial bid, increased our deposit, kept the inspection contingency, but threw out the mortgage contingency. At closing we found out that the other bidder’s final offer was more than ours, but they put in too many stipulations which turned off the seller. Needless to say we were pleased that this tactic worked. We have no regrets and love our home!
I’ll be honest and say that between Mr NerdyWife and me, I was the one bellyaching over tossing that mortgage contingency. It was in the middle of the real estate bust and banks weren’t as mortgage-happy as they used to be. He had been out of fellowship for only 1.5 years and was not yet partner in his practice. I certainly wouldn’t have been able to pay the mortgage on my part-time income alone so I wondered how the bank would view us. The prospect of not securing financing meant that all that we had been saving for in investments and retirement would go toward purchasing the house. And the thought of paying those early withdrawal penalties and taxes…ouch.
As mentioned in the post, we did run into a low appraisal. So we had to put 15% more down on top of the 20% down payment. It wasn’t really a problem though since those years of low rent afforded us a healthy cash savings with plenty left to spare. When we re-financed to a lower rate 1.5 years later, the appraisal came in higher than the purchase price but we had done very little work on the house. Appraisals are strangely subjective despite what they tell you.
Realized I stated that wrong. Of the 15% addl down payment, 5% was due to the low appraisal and 10% was due to the lender’s down payment reqt for the type of mortgage we obtained (30% down payment for a 20 yr fixed jumbo).
Scarcity mentality. That’s pretty much the only time when avg person would do something like this. There’s essentially no reason to undercut yourself on options to back out, should you need to. If a deal is so sweet to where this is financially beneficial, there will be numerous people competing for it and you’re not likely to win anyway. The truth is that just like dating, if you don’t get this specific one, your life isn’t over and that there’s a billion fish in the sea.
There’s likely another house 99.9% as attractive overall that won’t require you to put yourself on the line as much.
Agree completely. We have bought four houses over the years. We have walked away from our first choice three of those times and ended up in a better house each time. The fourth is the house we are now in. We got a great deal by walking away initially. So often in real estate you make your money at the buy end with a great deal, even on the house you end up living in.
If you have a high likelihood of not obtaining financing, then I agree with you completely. Better to walk away. From our standpoint, we felt that our risk was low. We had a very short list of practical things in a house that we were not willing to compromise on, none of which had anything to do with how attractive the house was. The inventory was lean and after 3 years of looking, we walked away many times from competing bids. This was in the middle of the real estate slump. Our growing family needed more than a 2 bdrm rental. This is just a tactic to appear more favorably in the eyes of the seller without overpaying the market worth of the house in the midst of a bidding war. Ultimately you have to ignore emotion, weigh your risk, and act accordingly.
From the practicality of your past comments I knew there was a rational reason why you guys chose an all cash offer. Did the three year time frame of looking play into your decision? I would imagine you could feel more comfortable and secure with your job choices and location at that point. We bought before we knew if the jobs were going to work out. Twice they did not, and we were glad we didn’t get burned in buying so quickly. Very smart of you to rent for a while before buying. Was it an intentional decision to rent initially?
We could’ve continued to look had I not been pregnant with our second. 🙂 His job was going well, partnership was imminent. And while I had transferred to part-time after the birth of our first, my employment looked to be steady as far out as I could tell at the time. We really only rented to save money and pay down his school loans which thankfully are long gone.
I certainly wouldn’t advocate an all cash offer to anyone. You really have to have your financial house in order and understand what you are getting in to.
Excellent article, solid well balanced information. I hope the author will provide information on other aspects of home buying, perhaps on ‘down-sizing’.
Another common strategy that is common in my market (Silicon Valley, where sales price often goes 10-20% over ask) is the new program that several banks have rolled out: the Cash Recoup. The concept is that you place an all cash offer, close, and then instantly obtain a loan. The loan is considered a purchase loan, not a refinance. The benefit to a purchase loan is that the terms are more favorable. (ie rate.) This makes buyers most competitive by showing cash up front, but still gives them the opportunity to finance with today’s low rates.
I don’t know many docs buying homes in Silicon Valley who have $1-2M sitting around in cash.