Why a seller should insist on a condition of finance
In a very active, fast-moving, competitive real estate market where property prices are rising at unprecedented levels, my clients ask me what they should do to protect themselves from potential financial losses and disappointment and yet still be competitive- this is a very relevant question for anyone purchasing a home. However, I believe it is not just applicable to buyers but also very relevant to sellers. Hopefully, this article will give buyers and sellers information to protect themselves, purchase the property they want and attract good buyers.
Before we start, it is essential to note that this article has been written from a mortgage risk perspective. I will point out mortgage risks and their consequences [and unintended consequences]. However, I am not a realtor, lawyer, or anything else, so this is not legal, nor real estate or any other advice reserved for those who are licensed to provide such advice.
I have never negotiated the sale or purchase of a property on behalf of a third party. However, I have purchased and sold a few of my own homes, and I have been a mortgage broker for more than 15 years, so I have seen many purchase and sale transactions. In some of those transactions, sellers and buyers were intentionally protected; in most of them, the outcomes were left to chance, and thankfully nothing went wrong. But, unfortunately, in others, the buyers or sellers suffered losses because of circumstances either out of their control or neglect by those who could have helped.
I have learnt from my clients and good realtors and applied these lessons to my home purchases and sales. As a result, I have thankfully never suffered related losses. Although incomplete, here are some questions I developed in my own learning that may help you to understand mortgage risks associated with buying and selling of residential real estate:
- What is a pre-approval/pre-qualification?
- What is a Condition of Finance [COF]?
- What happens when a borrower cannot meet their lender’s terms & conditions?
- Who gains if a buyer does not or cannot secure a COF?
- Does a seller gain when a buyer does not have a COF?
- When will a seller discover that their buyer has not secured mortgage financing?
- What are the consequences if a mortgage transaction does not close?
- Should a seller offer a COF to their buyer?
Let’s explore these questions one at a time and see what we learn.
What a COF is, whom it benefits and what should be accomplished during the COF period, etc., are very important, and you should ensure that you know these details so that, where possible, you can insist your lender uses the COF to protect you.
Even though the answer to this question should be pretty straightforward, it seems to be as elusive as the Loch Ness monster. So let’s start with the terminology; what is the difference between a pre-approval and pre-qualification? Don’t feel bad if you don’t know the difference because we in the industry use the two names interchangeably and confuse people even more.
Of the two names, I like “pre-approval” less because the “approval” part in “pre-approval” is unintentionally misleading since it gives home buyers the impression that their mortgage is already approved and all they need to do is find a property, but this is dangerously untrue. Although I will be using “pre-qualification” in this article, I believe “Mortgage Eligibility” is an even safer, better and more realistic term for what you should expect from the pre-purchase mortgage process; however, the industry does not recognize that term, so I will stick to “pre-qualification.”
Despite the confusion with the name for the pre-property purchase stage, what should matter to you is how your lender prepares you for your property purchase. Here are the minimum steps that you should expect from your mortgage broker or financial institution during pre-qualification:
- Application: Understand your needs and gather personal, financial, property, etc., information from you. Although this can be done through an online form or emailed application, we do this by phone because it builds trust and facilitates questions and clarifications better.
- Consent: We require your written consent to communicate electronically with you and to check your credit. Your pre-qualification depends significantly on your credit status. That is why we need to check it before determining your mortgage options.
- Supporting Documents: We request all your primary mortgage support documents from you—[E.g. down payment & closing costs confirmation, income confirmation, etc.]. Your mortgage support documents represent your mortgage conditions, so they are essential to your mortgage eligibility.
- Mortgage Options & Rules: Meet with you for about an hour to conduct an Options review meeting. During the meeting, we review your credit, current market conditions and interest rates, mortgage risks, mortgage rules, various mortgage options, closing costs, mortgage privileges and pitfalls, the typical mortgage process, your required documents once you have purchased a property etc.
- Pre-qualification: After your Options review, you should have a good understanding of your personal mortgage eligibility, and you should be pre-qualified for a mortgage, subject to your eligibility. This may seem obvious, but the pre-qualification process should be a lot more about helping you understand your mortgage eligibility, risks and various loan options than focusing on interest rates. While interest rates are important, they can also be misleading and distract you from focusing on what is actually important. The wrong mortgage could cost you a lot more than the difference between two interest rates. Please note: If your financial institution or mortgage broker’s idea of a pre-qualification is emailing you an interest rate and/or a maximum purchase price, however, they have not requested documents from you nor met with you to review your mortgage options, you should be very cautious about the quality of the pre-qualification.
In conclusion, a pre-qualifications purpose is to help you understand your general mortgage eligibility before purchasing a property. Your final mortgage approval process can only commence once you have purchased a property and the lender has received your final mortgage application together with your accepted agreement of purchase and sale and property listing. Thus, pre-qualifications, by their very nature, exclude:
- Future Property: Since you have not yet purchased a property during the pre-qualification stage, your lender cannot evaluate nor appraise the property.
- Final Loan Approval and Terms and Conditions: Because there is no property yet, there can be no final approval, and you will be unable to review your lender’s approval and terms & conditions.
Because there are so many misunderstandings about pre-qualifications, so it is essential that we also clarify what pre-qualifications are not:
- A pre-qualification is not a guarantee of mortgage approval. All pre-qualifications are subject to lender final approval and lender terms and conditions. Since those terms and conditions are vast, ever-changing, vary between lenders and mortgage products, largely unknown to you and a mortgage lender has the right to ask you for anything, at any time, without prior warning or notice, to satisfy its lending criteria; you should be very careful to proceed with a property purchase without giving yourself the ability to exit the purchase process if you are ineligible or you don’t like the mortgage you are being offered.
- Pre-qualifications don’t replace final mortgage approvals. A pre-qualification cannot be a final mortgage approval because you have not purchased a property yet. Thus, your lender has not evaluated your final mortgage application nor your future property. Pre-qualifications are independent of a specific property, lender or mortgage product.
- Pre-qualifications don’t replace a Condition of Finance: Because a pre-qualification does not guarantee you a final mortgage approval, a pre-qualification should not be used to submit a firm offer on a property. The purpose of a Condition of Finance [COF] is to protect you if you are ineligible for a mortgage; you cannot secure a suitable mortgage, cannot fulfill your mortgage conditions, etc.
- Pre-qualifications are not underwritten the same way as a final mortgage approval: If they are underwritten at all, the vast majority of pre-qualifications are not underwritten in the same way as a final mortgage approval, so they are not accurate at all.
- Pre-qualifications don’t guarantee a mortgage rate, nor a specific mortgage product: Pre-qualifications are not property or product-specific, so as much as they can be helpful in a rapidly rising interest rate environments, they are not a guarantee of interest rates, nor do they reflect the same interest rates as final mortgage applications.
Here is standard text a buyer may insert in their offer to purchase:
“This Offer is conditional upon the Buyer arranging, at the buyer’s own expense, a new First Charge/Mortgage. Unless the buyer gives notice in writing delivered to the seller personally or following any other provisions for the delivery of the notice in this Agreement of Purchase and Sale or any Schedule thereto not later than 6:00 pm, five business days after acceptance of this agreement, that this condition of finance is fulfilled, this offer shall be null and void. The deposit shall be returned to the buyer in full without deduction. This condition is included for the benefit of the buyer. The condition may be waived at the buyer’s sole option by notice in writing to the seller as aforesaid within the period stated herein.”
Definitions may vary in the industry, but in general, a condition of finance stipulates a period during which a buyer must secure suitable mortgage financing, at their sole discretion, for the purchased property. Failure to fulfill this condition will result in the transaction being cancelled and the buyer exiting the purchase process without incurring significant costs.
The COF is for the buyer’s benefit, so buyers should use it to its maximum to protect themselves. Here are the minimum items we aim to complete for our clients before the COF expires:
- Secure a Final Mortgage Approval
- Immediately once you have purchased a property provide your mortgage broker with the fully executed, accepted purchase agreement and MLS listing so we can submit your mortgage application for evaluation. If all goes well, you should receive a mortgage approval within one or two banking days, but depending on the lender and your circumstances, this could take up to 3 weeks.
- Fulfill the Primary Mortgage Conditions:
- Final mortgage approvals are subject to terms and conditions. Your mortgage support documents represent most of your mortgage conditions. To fulfill these conditions as soon as possible, we require your primary mortgage support documents [credit, income, down payment, etc.] up-front.
- Appraisal Completion:
- In Canada, every property involved with the mortgage financing is appraised, and lenders will finance on the lower of the property’s appraised value or purchase price. An appraisal must be ordered by your mortgage broker, from a lender accredited appraiser, and only once the mortgage is approved.
- It is essential that the appraisal is completed and accepted by the lender before the COF expires so that the buyer can either renegotiate with the seller or the buyer can exit the purchase process if the appraisal is unsatisfactory.
- Review the Mortgage:
- We meet with our clients to review their lender’s mortgage approval, to give them a chance to ask questions and/or change or accept their mortgage or exit the purchase process at their discretion.
- Mortgage Signatures:
- Clients review and sign their mortgage documents.
The COF is designed to protect the purchaser in case they cannot secure a suitable or any mortgage at all; however, the COF protects almost every participant in the mortgage process
All mortgage approvals are subject to the borrower meeting the lender’s terms and conditions. If a borrower cannot meet their lender’s terms and conditions, the mortgage cannot close, and the borrower is in jeopardy of legal action and/or they can suffer severe financial losses.
If a buyer cannot secure a COF, they essentially remove their right to obtain final mortgage financing. If they are ineligible for a suitable mortgage, they also lose the possibility to exit the purchase process without incurring significant costs. Suppose the buyer is ineligible for a mortgage. In that case, they may not be able to close their purchase transaction, which means their seller will also not be able to complete their purchase transaction, which means both the buyer and seller may suffer severe financial losses.
The answer to this question is not specific. However, from my buying and selling experiences, I have used the COF as a negotiation tool. By affording them a COF, I have attracted better buyers without lowering my property’s sale price because of the COF. Sellers may not understand that by requiring a buyer to exclude a COF from the offer to purchase, the seller also introduces considerable risks to themselves because the seller loses the ability to stipulate COF terms or determine whether their purchaser has secured mortgage financing.
By not knowing whether their buyer has mortgage financing, the seller cannot be sure that their sale will close, and in turn, their purchase will close. If a buyer cannot close on a purchase, all parties are affected and may suffer loss, so does a seller gain when they require a buyer to remove the COF from an offer to purchase?
If a seller has denied a seller a COF, the seller usually discovers through their solicitor, a few days before the closing date, that their buyer cannot secure mortgage financing and/or their sale will not close. Is denying a buyer a COF worth the seller’s risk of not closing their sale and, as a result, also their purchase?
A transaction that does not close is usually bad for all parties. Other than the hardship and stress suffered by all involved, let’s look at how some of the parties involved in the mortgage process may be affected:
- Buyer: A buyer may partially or entirely forfeit their deposit and/or face legal action from the seller. If a buyer does not forfeit their deposit, it may be held up in the seller’s Real Estate Broker’s Trust Account until the dispute is settled.
- Seller: Since a seller’s mortgage approval and down payment for their purchase is usually subject to the sale of their current home, they may not be able to close their purchase transaction. This means that the seller could default on their purchase, causing them to face the same consequences as their purchaser.
- Solicitor: The solicitor will charge the purchaser and seller additional legal fees for the additional services they offered.
- Realtor: The realtor may or may not be paid from the deposit paid by the purchaser.
- Mortgage Broker: Prime mortgage lenders pay mortgage brokers only for closed mortgage transactions, so mortgage brokers are typically not compensated for failed closing. Additional to the income loss, a mortgage broker’s status with the mortgage lender may also suffer due to a failed closing.
- Mortgage Lender: Mortgage lenders incur significant administrative and funding costs when mortgage transactions don’t close. Failed mortgage closings are later reflected in lenders’ stricter underwriting guidelines and funding costs, which may translate into higher future interest rates.
Most great and seasoned realtors value thorough and dependable pre-qualifications and usually won’t represent purchasers unless they have been appropriately pre-qualified. Therefore, accepting only offers from buyers that have been pre-qualified should be an essential starting point for any seller.
While the choice to offer their suitable, prospective buyers a COF is up to the discretion of every seller, sellers that mandate a COF to their buyers and require their buyers to complete some minimum procedures during the COF period should reap some of the following benefits:
- Better control: A seller is in much better control of the purchase and sale process if they require their buyer to secure a final mortgage approval and fulfill their primary mortgage conditions, including the appraisal, before the COF expiration. While giving their buyer a COF is no guarantee that the buyer will close their mortgage, it is a lot better than the seller removing their own right to some assurance.
- Assurance of outcome: A seller protects and gives themselves the best chance of closing their own purchase, thereby severely limiting their chances of incurring additional costs and/or suffering financial hardship.
- Better Buyers: While it is true that a COF period could delay the sale process, especially if a prospective buyer cannot obtain financing, it is also true that a seller may attract better buyers if a buyer is appropriately pre-qualified and the buyer is prepared to meet the seller’s COF requirements.
- Selling Price: As a seller in a market where almost no sellers afford their buyers a COF, I have been able to demand higher prices from my buyers in exchange for a welcomed COF.
In conclusion, let’s ask the questions again, with a fresh perspective; what is the benefit of requiring a buyer to waive their COF and who benefits from a transaction without a COF? I will leave the answer to the questions to your own discretion, but why, when there is so much at stake, is not knowing a good idea? When both buyers and sellers could suffer unnecessary stress, turbulence & financial loss if a real estate transaction does not close, does it benefit the seller or buyer to remove the COF and insert unknowns and risks into a transaction? I don’t think so.
- Subject to change at any time and without prior notification or warning
- Subject to lender approval and lender terms & conditions
- For information purposes only
- Based on estimates
- The article is based on generic information and is not based on any specific lender and/or mortgage insurer’s programs.
- This information cannot be used for decision-making purposes.