Real Estate Holdbacks—Why They Often Don’t Make Sense for Lenders
| February 24, 2022
by Gary Siegle, RECA Regulatory Compliance Advisor, Mortgage Brokers
RECA has received an increase in inquiries regarding the use of holdbacks in real estate sales contracts.
A holdback occurs in a real-estate transaction when the buyer identifies a condition (typically a renovation or repair) that they want to be completed at the seller’s expense. The holdback is typically a pre-determined dollar amount withheld from the seller until the condition named in the agreement has been completed. This may or may not occur prior to the buyer taking possession of the property.
In some circumstances, when the condition that determined the need for a holdback is not completed prior to the closing date, it can cause problems for the lender or mortgage broker. Especially if they haven’t been told of the holdback prior to the financing conditions being waived.
The problem is, if the work is not completed, often the holdback is returned to the buyer, effectively reducing the selling price.
What kind of problems do lenders encounter with holdbacks?
If the real-estate transaction is insured (less than 20% has been put down) the holdback can sometimes cause the loan-to-value ratio to increase above the maximum threshold of 95%. If the loan-to-value ratio is between 80% and 95%, the change to the effective selling price can move the loan-to-value ratio into another mortgage insurance premium tier. Either scenario means that the lender is now offside on the default insurance, and if there is ever a claim the insurer may not pay.
Holdbacks can also cause problems in conventional real-estate deals when the holdback amount reduces the price, and the amount put down is no longer enough to deem the mortgage conventional.
Lenders will not risk breaching their regulatory requirements and often reject applications where the holdback is structured to be refunded to the buyer in the event the work is not completed.
Don’t Forget About Errors and Omission Insurance
All mortgage brokerages are required to carry Errors and Omissions insurance. This insurance policy needs to be purchased independently and renewed at the policy expiry date. A mortgage broker must also ensure the business of the brokerage is carried out in accordance with the legislation. The number one issue RECA sees for its mortgage broker licensees is the failure to carry Errors and Omissions Insurance or the failure to renew their policy once it has lapsed. In some cases, RECA has seen brokerages who did not have Errors and Omissions Insurance for years yet continued to handle multiple mortgage files.
A reminder that mortgage brokers need to carry Errors and Omissions Insurance on a continuous basis and the failure to do so, means you should not be operating. Operating uninsured puts your clients at serious risk. Operating without Errors and Omissions Insurance also opens mortgage broker licensees to the possibility of sanctions.
Evidence Is Key when Submitting Anonymous Fraud Tips
RECA’s mandate includes protecting against, investigating, detecting and suppressing fraud as it relates to the real estate and mortgage industries. Did you know RECA has an Anonymous Fraud Tip Submission Form? Consumers, industry licensees, or other third parties can anonymously provide RECA information regarding fraudulent activity they may be aware of taking place in the industry. RECA takes the allegations they receive through this form very seriously; however, RECA’s investigation team can rarely act on “tips” alone. Anyone submitting these forms needs to be very specific with the information they are providing and make sure to submit any relevant supporting documents.
For instance, RECA recently received an anonymous fraud tip that provided details of a company which was reported to be falsifying legal documents in order to qualify buyers who otherwise would be deemed unqualified. The tip was very detailed but provided no form of supporting evidence, just an accusation. Although the tip may very well have contained valuable information, without supporting evidence, the investigation could not move forward. RECA requires sufficient grounds to open an investigation.
Supporting evidence is paramount in making sure any potential investigation moves forward. There is a section in the Anonymous Fraud Tip Form where this type of information can be submitted.
What can be done?
Real estate transactions are complex in nature and often involve many professionals. For example, one transaction could include two real-estate licensees, a mortgage licensee, multiple lawyers, and potentially other parties like a home inspector. All these professionals need to be communicating with one another so that the interests of both the buyer and the seller are protected. The conditions that are being negotiated need to be communicated beforehand to all parties, including any potential holdbacks.
There are several matters that can be negotiated between the seller and buyer that may negate the need for a holdback, or, in the rare case a holdback needs to occur, its use needs to be communicated properly to the lender/mortgage broker, so they can ensure the circumstances don’t put the loan in jeopardy of being offside of its original conditions.
Alternatives to holdbacks:
- arrange to have the work completed before the possession date
- seller can reduce the price of the property and leave the work requested uncompleted for the buyer to complete themselves after possession, removing the need to do a holdback
In the end, buyers always need to be in contact with their lender throughout the financing process. Constant and consistent communication between all parties will allow for a successful transaction.
If it is determined that it is the best-case scenario to use a holdback, it is best practice to hold the funds in a lawyer’s trust account until the work has been completed and conditions met. Consult with the lender as to how the holdback should be disbursed to avoid approval withdrawal.
There should also be a defined timeline listed for the work to be done. For instance, list that the defined work needs to be completed within 60-90 days of possession or the holdback will be returned to the buyer’s lender, reducing the overall value of the loan.