Plan A for contingencies: Lessons for buyers

REThink Real Estate

By Inman News Feed
Add Comment Add Comment | Comments: 0 | Posted May. 13, 2010

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REThink Real Estate

Tara-Nicholle Nelson
Inman News

Q: I'm getting an FHA loan to finance my first home. I'm in contract right now. Our appraisal is done and the house appraised for the sale price but the loan process is not yet done, although I was preapproved. My agent says the lender has to review the appraisal.

I'm confused about the difference between the loan contingency and the appraisal contingency. My agent says I should remove the appraisal contingency, but I'm not sure about that.

A: In an FHA loan scenario on today's market, the appraisal and loan contingencies are much more closely linked than in other situations and times. This is because Federal Housing Administration-insured loans have a set of minimum standards for the condition of the homes being financed, much more so than with conventional (non-FHA) loans.

An FHA appraiser is tasked with verifying that the property does meet these condition guidelines -- or, if it doesn't, calling out the deficiencies.

In most non-FHA scenarios, the biggest issue with an appraisal is whether the property will appraise for the purchase price. With an FHA loan, though, the mortgage lender's review of the appraisal is critical, as it can often result in additional conditions being placed on the loan, which may or may not be feasible.

For example, if the appraiser feels a deck or stairway is unsafe, or if he or she points out a missing stove or damaged linoleum, the lender may require that item to be repaired or replaced before funding the loan. If the buyer and seller in such a case cannot come to terms on how this repair can happen before closing, the deal might die.

Similarly, the loan underwriter might disagree with the comparables or other analytics used by the appraiser to support her opinion of the home's value -- and this can happen with both FHA and conventional loans.

In these cases, the underwriter can ask the appraiser to recalculate the home's value or can simply cut the value, unilaterally. The underwriter's job is to assess the risk any given loan presents and allow funding only for loans that fall within an acceptable level of risk.

Banks are pretty risk-averse right now, so underwriters are very tough and careful -- especially in their review of the appraisal. If your loan goes south, and you stop making the payments, the underwriter wants to be super sure the bank can recover what it lent you from the property itself.

Now, to the basics underlying your question. A contingency is simply your right to bail -- your right to back out of the contract, for a certain reason. Many states' real estate purchase contracts include contingencies for inspections, appraisals, financing (loan), insurability and many other grounds on which a buyer can legitimately back out.

Most contracts articulate these contingencies in a series of paragraphs with default timelines and fill-in-the-blank alternatives to the default, empowering buyers and sellers to negotiate a customized contingency removal schedule based on when the buyer believes he or she will be ready to remove a given contingency, and when a seller requires the certainty of that contingency removal.

Sometimes, all the contingencies run shorter or longer than the default, but all of them run on the same timeline. Other times, the various contingencies are set on different deadlines.

Once the parties sign the contract, the buyer and her representatives immediately launch a series of due diligence activities to get the buyer the information she needs to know about whether to exercise or remove her contingencies.

That information typically includes details of the home's condition (goes to the inspection contingency), the appraised value of the home (appraisal contingency), and the final approval of their financing (loan contingency).

When the timeline for any given contingency is up, the buyer has the option to exercise a contingency (canceling the deal and, usually, recouping the deposit money), or remove it (indicating that the buyer intends to move forward with the transaction).

In California, for example, when a contingency deadline arrives, the buyer who wants to move forward must actually sign a document that removes their contingency.

In most cases, if the buyer elects to back out of the transaction after proactively removing their contingencies, their earnest money deposit is forfeited to the seller as "liquidated damages," avoiding the need for a lengthy court dispute, but penalizing the buyer by tens of thousands of dollars in many cases.

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