[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.
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]
The “All Cash” Offer
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.
Getting 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.
Getting Your Money Back
Are there any other ways to get your 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!