When a purchaser is borrowing to purchase real estate it is essential that finance is approved before the matter proceeds. If finance is not approved at the time the contract is signed, a finance condition must be included in the contract. Without a finance condition a purchaser is at serious risk.
Before entering into a contract to purchase real estate, a purchaser needs to know if finance is available. In this section we examine the difference between conditional and unconditional finance, the options available to purchaser whose finance is not approved, and how a finance condition works.
|Why buying “subject to finance” can be so dangerous|
|Is finance approved?|
|If finance is not yet approved|
|How the finance condition works|
Why buying “subject to finance” can be so dangerous
The first thing to bear in mind is the fact that the vendor wants to be certain that the property has sold. A sale that is “subject to finance” can fail completely if the purchaser’s finance fails, and so the vendor cannot be sure that property has acutally sold until the sale becomes “unconditional” (i.e. confirmed, and not dependent on any conditions).
A vendor should sell before buying again
Most vendors who sell are also purchasers, but a vendor cannot commit to a new purchase unless and until their sale has become “unconditional”. In some cases a vendor may commit to a purchase, even though their sale remains “subject to finance”, using a special condition which will allow them to cancel if their sale falls through.
A careful vendor will always wait until their sale has become unconditional before committing to the purchase of another property.
Unconditional – How does the vendor know?
The vendor will want to be sure that their sale is unconditional before proceeding with a new purchase, but how does the vendor know when the sale has become unconditional? The most common ways are:
- The purchaser may confirm in writing that the contract is unconditional.
- The purchaser’s finance condition may expire, resulting in the contract becoming unconditional.
It is quite common for purchasers to make mistakes when determining whether a contract has become unconditional, with disastrous consequences. Remember, an unconditional contract means that the sale must proceed. If the purchaser defaults on the contract because finance is not available, the vendor may be entitled to force the purchaser to proceed, or to forfeit the purchaser’s entire deposit and to sue for damages.
There may also be flow-on costs. Remember, many vendors will also be committed to a further purchase, and if the vendor defaults on their second purchase the loss and costs may also be claimed.
What are the most common mistakes?
Mistakes occur where the purchaser incorrectly believes that finance has been approved, or where the purchaser unintentionally allows the finance condition to lapse. The most common examples are as follows:
- Purchaser believes that “pre-approval” means the loan has been approved.
- Purchaser wrongly believes that all of the lender’s requirements have been met.
- Purchaser allows finance condition to lapse because of the above mistakes.
- Finance condition lapses because purchaser fails to give required notice.
- Finance condition lapses because purchaser gives late notice.
- Finance condition fails because purchaser fails to pay deposit when due.
- Finance condition fails because purchaser failes to observe all conditions of the finance clause.
Estate agent involvement
Estate agents are paid on commission and commission rage is always an issue where there is the possibility that a sale may be cancelled.
The estate agent is not paid if the purchaser cancels the contract pursuant to a finance condition, and it is common to find estate agents manipulating the finance condition in an effort to minimise a purchaser’s opportunity to cancel the contract. To this end, the estate agent will often offer to “assist” the purchaser in preparing the finance condition, while taking the opportunity to minimise the finance period, alter the period for the giving of notice, or even to talk the purchaser into using a lender-of-last-resort.
If the purchaser defaults on the contract, and the vendor becomes entitled to a forfeited deposit, the estate agent is entitled to take a commission from the forfeited deposit. Even if the vendor feels inclined to let the purchaser “off the hook”, the estate agent is entitled under the Exclusive Sale Authority to require the vendor to forfeit the purchaser’s deposit in order to pay a commissiosn to the estate agent.
Thus, an estate agent can actually profit by setting the purchaser up for failure!
In one case we have seen an estate agent substitute the standard finance condition for one that we would describe as extremely unfair.
Is finance approved?
How does a purchaser know that finance has been approved?
Usually the lender will provide written confirmation of loan approval. However, notification of home loan approval is not always reliable.
With strong competition in the mortgage industry, many lenders are unable or unwilling to complete the due diligence associated with the approval process in the short time demanded by mortgage consumers. In order to stay competitive, lenders have adopted a procedure where the borrower is told that the loan is approved, but the approval is “subject to conditions”.
In effect, the loan is not approved at all.
“Pre-approval” or “Approval In Principle” are terms used by lenders to make borrowers believe that finance has been approved when in fact it has not been approved at all.
At most, “approval in principle” and similar terms mean that the home loan will probably be approved if all of the assumptions made by the lender, based on the information provided by the intending borrower, are correct.
Of course, if any of the lender’s assumptions are not correct the lender reserves the right to withhold approval, or to cancel a conditional approval.
A loan that is “pre-approved” or “approved in principle” is a loan that is NOT approved!
Subject to valuation
“Subject to valuation” is the most typical requirement attached to a conditional loan approval.
In most cases the price paid for a property will be regarded as the new “current market value” of the property, and the valuation condition will be satisfied.
However, it is not unusual for a valuation to indicate that the purchaser has paid too much for the property. In such a case the lender may decide that the property will not secure the loan (i.e. if the borrower defaults on the loan and the lender is forced to sell the property it would not fetch enough to cover the cost of the loan), and reject the loan application.
We have seen one extreme case where RAMS Home Loans approved a client’s loan, then retrospectively cancelled the loan because the property concerned was not of sufficient size to satisfy the RAMS lending criteria. Initially RAMS stated that the loan was rejected on the basis of the valuation, however investigations revealed the true reason for rejection. After some argument RAMS finally approved the loan. It would appear that “valuation” is a term with a very loose definition.
Even where a purchaser believes that the property is most certainly worth at least the amount paid for it, there is a risk that the loan can be rejected. It must be remembered that a loan that is conditional on a valuation is a loan that is NOT approved.
A loan that is “approved” subject to any conditions is a loan that is NOT approved.
Even if finance is believed to be certain, unless the lender has provided written confirmation that the loan has been unconditionally approved a purchaser should proceed on the basis that finance has not yet been approved.
If finance is not yet approved
If finance has not been approved a purchaser will have to make a difficult choice – to proceed unconditionally, or to proceed “subject to finance”.
There are advantages and risks associated with proceeding unconditionally where finance has not been unconditionally approved.
The most obvious risk is that the purchaser will be required to proceed with the purchase, even if the application for finance is later rejected. This could result in court action to recover loss suffered by the vendor, and the forfeiture of the deposit (even if a small deposit has been paid, the vendor may be entitled to claim an amount equal to 10% of the purchase price from the purchaser).
However, if the purchaser does not proceed unconditionally the property may be lost to a competing purchaser. This is usually the case with auctions, where finance conditions are not allowed.
Proceed subject to finance?
Proceeding “subject to finance” is the preferable option where finance has not been approved unconditionally.
Of course, there is the risk that the property may sell to a purchaser who offers to buy the property unconditionally, but in most cases the vendor will opt for the higher price, rather than a lower but unconditional offer.
Buying real estate “subject to finance” is not unusual, and most contracts have provision for a finance condition.
How the finance condition works
The finance condition appearing in most contracts of sale and contract notes prepared on behalf of a vendor will require 3 items of information:
1. The name of purchaser’s intended lender. 2. The amount the purchaser needs in order to proceed with the purchase. 3. The date by which the purchaser expects to receive confirmation of unconditional approval.
The finance condition is ordinarily governed by General Condition 3 of the standard Contract of Sale of Real Estate, which appears in the following form:
“3. This contract is subject to the lender approving the loan on the security of the property by the approval date or any later approval date allowed by the vendor. The purchaser may end the contract if the loan is not approved by the approval date only if the purchaser:
- (a) has made immediate application for the loan;
- (b) has done everything reasonably required to obtain approval of the loan;
- (c) served written notice ending the contract on the vendor on or before two business days after the approval date; and
- (d) is not in default under any other condition of this contract when the notice is given.
All money must be immediately refunded to the purchaser if the contract is ended.”
We will examine each of these requirements in under the headings below.
The requirement to make “immediate application” for the home loan ensures that the purchaser cannot deliberately miss out on finance by refusing or failing to apply for the loan.
As to whether the purchaser has actually made immediate application will depend on the circumstances. (For example, a purchaser who has to wait until after the Christmas break to apply for their home loan will be regarded as having satisfied this requirement if the application is lodged as soon as is practicable in the circumstances.)
Legal advice is important where a purchaser has not already applied for a home loan at the time the contract has been signed, unless the application is to be lodged within, say, 48 hours of the day of sale.
Everything reasonably required
Some purchasers believe that the finance condition can be used as a “cover all” contract cancellation condition. For example, we are often asked if a purchaser can end a contract by simply refusing to sign or return bank documents, or failing to provide tax returns or pay slips, where this will inevitably lead to non-approval of the loan application.
Deliberately bringing about the failure of the loan application is likely to breach this clause of the finance condition.
Serving written notice
If the purchaser is unable to obtain unconditional finance approval by the date stated in the sale contract, the contact can be ended.
To end the contract the purchaser must serve written notice on the vendor or the vendor’s solicitor or estate agent within 2 days of the stated date.
It should be noted that the finance condition does not make any mention of a right for the purchaser to extend the time. Estate agents often persuade purchasers to allow a short period of time for loan approval, telling them that if the period is not long enough an “extension” can be sought. This is quite incorrect.
An extension of time can only be obtained through negotiation, and a party cannot negotiate unless they have something to offer the other party. In this case, the purchaser must actually CANCEL the contract, and then negotiate an extension of time in return for the reinstatement of the contract.
Cancelling the contract in this way, while keeping the purchaser safe, does carry a risk. This is because the vendor may accept the cancellation, and sell the property to someone else. In such circumstances the purchaser’s only options may be to cancel the contract or to allow it to become unconditional.
Not in default
Assuming that the purchaser has complied with all of the requirements of the finance condition by applying for the home loan as soon as possible, trying hard to have the home loan approved, and serving written notice on the vendor within 2 days of the expiry date if the loan is not approved, there is one more condition to be satisfied before the purchaser can finally end the contract.
The purchaser must not be in default of any other condition of the contract at the time the notice is served on the vendor.
While no purchaser intends to breach the contract, it is quite common for purchasers to be in breach through non-payment of the deposit. A purchaser whose contract is subject to finance must ensure that the deposit is paid in full on or before the deposit payment date stipulated in the contract.
Legal advice should be sought by any purchaser who is unable to pay the full deposit on or before the due date.
Any purchaser who is borrowing in order to complete the purchase of real estate MUST ensure that the purchase contract is made “subject to finance”.
A purchaser who is relying on finance to purchase, and who does not include a finance condition in the contract is exposed to serious risk, and may be forced to proceed with the purchase, or forfeit the deposit or 10% of the purchase price, as well as being sued for the vendor’s loss and costs.
Estate agents should never be permitted to prepare the finance condition, or to advise a purchaser on the finance condition, as the estate agent’s involvement is often self-serving and contrary to the interests of the purchaser.
A purchaser should always obtain legal advice from a qualified lawyer regarding the correct use of the finance condition, including advice as to the circumstances where it may expire or otherwise become ineffective.