What to Consider When an Offer Includes an FHA Loan Contingency

​The Federal Housing Administration (FHA) was created by the federal government to provide mortgage lenders with insurance against losses if a borrower defaults on a loan.  FHA is not actually the lender.  FHA is really an insurance company that eliminates the lender’s risk so lenders will make loans to borrowers that they might otherwise deny.
 
Borrowers like FHA insured loans because of relaxed credit and income ratios , lowered down payments and less cash to close.  Sometimes a buyer that can’t qualify for a conventional loan will want to switch to an FHA insured loan. 
 
Should a Seller allow a Buyer to switch to an FHA loan?
 
First, a buyer that includes a conventional loan contingency in a contract cannot switch to an FHA insured loan (or VA or USDA) without an amendment to the contract. That is, the Seller has to agree.
 
Next, there are substantial differences in the Seller’s position if the seller agrees to an FHA loan.  A simple financing contingency that expires quickly can become a valid termination right before closing day.
 
Amendatory Clause and Repairs Clause
 
The FHA loan contingency offers protections to a borrower, required by FHA regulations, that are not found in a conventional loan, specifically, the Amendatory or appraisal and repairs clauses.  According to the FHA, operation of these clauses, cannot be eliminated.  Even if the finance period has expired, the contract can still be terminated due to a low appraisal or a failure to agree to repairs.  For that reason, some Sellers won’t accept an FHA insured loan contingency.  Termination due to appraisal or repair issues can happen right up to closing day, even if buyer has the ability to obtain the loan. 
 
Here’s an example:
A contract has an FHA loan contingency with 21 days from the binding date to determine if Buyer has the ability to obtain the Loan. The 21 days has expired and the buyer has the ability to obtain the loan.  However, the appraisal comes in low.
 
According to the Amendatory Clause in the FHA Loan contingency (paragraph 11), the Buyer can terminate and the Buyer gets the earnest money back.  The Buyer can decide to close, but it’s the Buyer’s choice.  There are, of course, ways that the parties can negotiate if the buyer and the seller want to negotiate. The Seller can reduce the purchase price or the buyer could pay the difference to the contract price or anything in between.  But if the appraised price is lower than the minimum value in the contingency and the Buyer wants to terminate, the buyer can terminate and will get the earnest money back. 
 
Here’s a second example:
The same facts as above, but the appraised price is not an issue.  Instead, the appraisal includes certain required repairs to the property that exceed the amount the Seller has agreed to pay in paragraph 15. 
 
According to paragraph 15 (Repairs), if the costs of repair exceed the amount agreed, 1) the Seller has to provide written statement of the repair cost and 2)
the Buyer and Seller have 3 days to negotiate and agree.  If they don’t come to an agreement, the contract automatically terminates. No one is in default.  The earnest money goes back to the buyer.
 
Conventional Loan
Compare this situation to a conventional loan contingency. The ability to obtain a loan and the appraisal contingency have expired.  It’s simply a cash deal now.  The buyer can bring loan proceeds to closing, but if the buyer does not and does not have the cash to close, the buyer is in default and the buyer’s earnest money is forfeited to the seller. 
 
Investigate the Situation
So, what if your seller is faced with a contract that includes a FHA loan contingency or a buyer that wants to switch from a conventional loan to an FHA loan?  Our recommendation would be to investigate before agreeing.  Is the appraisal going to meet the price?  Are repairs going to be an issue?  If the FHA loan looks good and the appraisal and repair issues look good, then it’s reasonable to agree.  If a buyer is asking to switch to an FHA loan. get some answers before agreeing.