- Mortgage Financing: Contract Protection Essential
Mortgage Financing: The Sales Contract Debate
By: Raymond J. Bowie, Esq.
"Neither a borrower, nor a lender be," wrote William Shakespeare, in an oft-quoted line from Hamlet. If he were to take his own advice today, however, the Bard of Avon, while perhaps the English language's greatest playwright, would not likely own his own home or achieve much as a real estate investor. That's because both borrowing and lending – mortgage financing – is what makes modern real estate transactions possible.
Even here in Naples, where all-cash purchases seem common in high-end residential sales, the vast majority of home sales and almost all commercial property transactions are sustained by mortgage financing. This makes financing the centerpiece of most transactions, the sine qua non or essential element without which the transaction would not be possible.
It's no wonder, then, that most real estate sales contracts devote extensive paragraphs to the subject of how the buyer is to finance the purchase, the terms of the mortgage the buyer is to seek, the consequences of the buyer's failure to obtain it, and the respective rights of the buyer and seller if that happens.
In most contracts, the mortgage financing provisions take the shape of a contingency clause, in which if the buyer fails to obtain the specified mortgage loan by a certain date, either the buyer or seller can cancel the contract without penalty. Inherently, mortgage contingency clauses favor the buyer, since the seller has taken his property off the market often for weeks or even months awaiting the results of a mortgage approval process beyond the seller's control, while the buyer suffers no penalty if he fails to get the loan. Because of this, mortgage financing clauses are a frequent cause of buyer/seller disputes and a current focus of efforts to achieve greater fairness in how such contract clauses are drafted.
For example, in most standard form sales contracts, mortgage financing provisions today include more buyer obligations and greater seller protections.
In entering into the sales contract, the buyer must specify the amount of the mortgage, the term of the loan (e.g.15 year, 20 year, 30 year), the type of loan (fixed or adjustable rate), and the interest rate for which the buyer is supposedly qualified. This allows the seller, counseled hopefully by a knowledgeable real estate agent, to evaluate whether the buyer's financing terms are realistic in light of the prevailing mortgage market – and if warranted, to reject or counter the buyer's financing terms. For example, if a buyer's contract offer states that the buyer's interest rate is not to exceed 6.00% on a 30-year fixed rate mortgage, a seller may rightfully be concerned that such a low rate would not be available, entitling the buyer to cancel the contract subsequently. In that situation, the seller might counter the buyer's mortgage clause by raising the interest cap to a more realistic 7.00% or changing it to "prevailing rate."
Sellers are also increasingly protected by mortgage clause provisions that require a buyer to make application for his mortgage with a lender within a few days of the contract date, and to pursue his application diligently and in good faith, including meeting any conditions imposed by the mortgage lender. Some contract clauses also require the buyer to apply to a second or third lender if the buyer is turned down by the first. These clauses address situations where buyers, sometimes because of changed circumstances or simply buyer's remorse, have deliberately delayed or sabotaged their loan applications in order to be denied financing to escape the contract. Other times, buyers have failed to disclose upfront to sellers that the buyers have their existing home to sell in order to qualify for the new mortgage. Under a "good faith" clause, if a buyer is proven to have done any of this, he loses the benefit of the mortgage contingency and forfeits his deposit to the seller.
Another feature in a mortgage clause that can protect the seller is a provision that allows the seller as well as the buyer to cancel the contract in the event that the buyer fails to obtain loan approval or waive the contingency by a stated deadline date. This way, a seller can limit the time the property is off the market and put the buyer under greater time pressure to satisfy the loan approval contingency.
And most recently, mortgage clauses are being re-written to delete all references to the term "mortgage commitment". Traditionally, a buyer could satisfy his obligations under the contingency by providing to the seller a mortgage commitment issued by the lender, as proof that the buyer had pursued his loan application in good faith. Years ago, if a lender issued a loan commitment it meant that perhaps barring only a low appraisal, the loan was approved and a sure thing to close. In recent years, however, mortgage industry practice has been to issue loan commitments hedged with a multitude of exceptions and conditions, leaving actual loan approval very much in doubt. As a result, contract mortgage clauses are increasingly requiring that for a buyer to satisfy his loan contingency, he must give notice to the seller that he has received loan approval. If his loan does not close thereafter, the buyer has assumed the risk of losing his deposit.
Variations of these types of mortgage clauses, more fairly balanced between the interests of buyer and seller, are beginning to appear in the real estate sales contracts commonly used in Florida.
The Sales Contract predominantly used in Collier County, published by the Naples Area Board of Realtors, still requires that the buyer secure a "mortgage commitment" to satisfy the loan contingency. However, this clause is in the process of revision this year. The likely result will be a mortgage clause requiring the buyer, in order to satisfy the contingency, to notify the seller when the buyer actually has loan approval rather than simply a commitment.
Recent developments in the mortgage industry may, however, make it possible for buyers and sellers to avoid the uncertainties and difficulties of the mortgage contingency clause. Mortgage lenders now have available automated, computerized loan underwriting programs that allow most borrowers to be financially qualified for VA, FHA or conventional loans within days or even hours of application. No longer does it take weeks of uncertainty to process and underwrite the typical mortgage. This technological development opens up new possibilities for financing clauses in sales contracts as well.
Prudent buyers are already been advised to make loan application with a mortgage lender before writing a contract to buy a property, in order to become "pre-approved" for the required financing terms. Mortgage lenders will issue pre-approval letters to buyers confirming that the buyer's credit, income and assets have been reviewed and qualify the buyer for a stated loan amount and terms. This allows the buyer to present a contract offer to the seller without the need for a lengthy mortgage contingency period and the accompanying uncertainty posed the seller.
As an alternative to the traditional mortgage contingency clause, prudent buyers can offer to furnish written pre-approval of loan qualification to the seller upon contract acceptance, making the contract contingent thereafter only upon either the property appraising at a value sufficient to support the loan or the seller's agreement to reduce the price to allow the financing. Such an alternative would alleviate much of the uncertainty, ambiguity and indeed litigation that surrounds traditional mortgage contingencies.
The mortgage clause is perhaps the most rapidly and constantly evolving provision in sales contracts nationwide. Will the loan pre-approval clause eventually take the place of the mortgage contingency clause? As with all contract clauses, buyer and seller preferences will ultimately determine.