Among the biggest changes we have seen in our market post-Lehman is the return of the financing contingency. Prior to Lehman and the seizing up of the mortgage credit markets, it was quite typical for buyers to “waive” a contingency and accept the risk of financing. With contract deposits typically 10% of purchase price, this can be a hefty bet on your banker’s ability to deliver. But qualified purchasers were confident, and indeed there was good reason for such confidence: mortgage rejections were rare, and those with good income and credit ratings were nearly certain to find at least one lender willing to make a loan.

But those days are over. Today, the pendulum has swung, and the market norm for transactions of less than $2 million is that a qualified buyer will ask for – and get – a financing contingency in the contract of sale. So what exactly, does that contingency mean?

I explain this concept to my clients this way: contracts are about allocating risk between the parties. For example, what happens if the apartment is destroyed by fire prior to the closing? What if there is an active leak that occurs before we close? These are risks that a properly drafted contract address. And the risk of financing is no different. In the absence of a contingency, that risk remains entirely with the buyer. But in a standard financing contingency, most of that risk moves to the seller. So if the buyer applies to a bank, provides accurate information promptly, and the bank rejects the buyer within a certain period, the buyer can elect to terminate the deal and get her 10% downpayment returned. But if the buyer loses their job the day before closing, and as a result the bank cannot verify employment and will not fund the loan, the typical language in a financing contingency would allocate that risk to the buyer. And most sellers would agree that such a risk is properly for the buyer.

So where exactly is the line drawn, and when does the risk shift from seller to buyer? Here’s how it works. The contract creates a loan contingency period, typically 30 to 45 days, during which the buyer must apply for a loan and cooperate with the bank to provide requested documents. At the end of this period, a window opens for a period of a few days in which the buyer can elect to terminate the deal if (1) they have not received a loan commitment letter from the bank, or (2) they have received a denial on their application. For the purposes of the contract, a loan commitment letter is a legally binding obligation by the bank to make the loan conditioned on any factor other than appraisal.

And that’s where it starts to get tricky. An example will help. Suppose the bank issues a loan commitment letter conditioned on a number of typical factors (e.g. verification of employment within 24 hours of funding the loan for example). But the letter is also conditioned on the buyer selling his existing apartment prior to closing on the new loan. That might not be something the buyer was planning on doing, but if the bank will not withdraw this condition, the buyer is stuck with a loan commitment letter than has shifted the risk of financing to him, but with a condition that might not permit them to actually close on the new loan due to the difficulty in complying with that condition. Not a good place to be for the buyer, and not a risk they likely were ready to take on.

But appraisals are different. If the loan commitment is issued conditioned on appraisal, it’s not a loan commitment letter as that term is defined in the contract. So until the bank clears that condition, the buyer is in the same position as they would be if no letter had been issued, or if they had a rejection. Even if the appraisal comes in just a few thousand short of the purchase price, most contracts would permit the buyer in that situation to terminate the deal and obtain a return of their 10% contract downpayment.