A contingency clause defines a condition or action that must be met in order for a real estate contract to become binding. A contingency becomes part of a binding sales contract when both parties (i.e., the seller and the buyer) agree to the terms and sign the contract. Accordingly, it is important to understand what you’re getting into if a contingency clause is included in your real estate contract. Here, we introduce widely used contingency clauses in home purchase contracts and how they can benefit both buyers and sellers.
Real Estate Contracts
A real estate transaction typically begins with an offer: a buyer presents an offer to purchase to a seller who can either accept or reject the proposal. Frequently, the seller counters the offer and negotiations go back and forth until both parties reach an agreement. If either party does not agree to the terms, the offer becomes void and the buyer and seller go their separate ways with no further obligation. If both parties agree to the terms of the offer, however, the buyer makes an earnest money deposit – a sum paid as evidence of good faith, typically amounting to 1% of the sale price. The funds are held by an escrow company while the closing process begins.
Sometimes a contingency clause is attached to an offer to purchase real estate and included in the real estate contract. Essentially, a contingency clause gives parties the right to back out of the contract under certain circumstances that must be negotiated between the buyer and seller. Contingencies can include details such as the timeframe (e.g. “The buyer has 14 days to inspect the property") and specific terms (e.g. “The buyer has 21 days to secure a 30-year conventional loan for 80% of the purchase price at an interest rate no higher than 4.5%"). Any contingency clause should be clearly stated so that all parties understand the terms.
If the conditions of the contingency clause are not met, the contract becomes null and void, and one party (most often the buyer) can back out without legal consequences. Conversely, if the conditions are met, the contract is legally enforceable and a party would be in breach of contract if he or she decided to back out. Consequences vary, from forfeiture of earnest money to lawsuits. For example, if a buyer backs out and the seller is unable to find another buyer, the seller can sue for specific performance, forcing the buyer to purchase the home.
Types of Contingency Clauses
Contingency clauses can be written for nearly any need or concern. Here are the most common contingencies included in today’s home purchase contracts:
An appraisal contingency protects the buyer, used to ensure a property is valued at a minimum, specified amount. If the property does not appraise for at least the specified amount, the contract can be terminated and the earnest money, in many cases, is refunded to the buyer. An appraisal contingency may include terms that permit the buyer to proceed with the purchase even if the appraisal is below the specified amount, typically within a specified number of days after the buyer receives the notice of appraisal value. The seller might have the opportunity to lower the price to the appraisal amount. The contingency specifies a release date, on or before which the buyer must notify the seller of any issues with the appraisal; otherwise, the contingency will be deemed satisfied and the buyer will not be able to back out of the transaction.
A financing contingency (also called a “mortgage contingency”) gives the buyer time to apply for and obtain financing for the purchase of the property. This provides important protection for the buyer, who can back out of the contract and reclaim his or her earnest money in the event he or she is unable to secure financing from a bank, mortgage broker or other type of private lending. A financial contingency will state a specified number of days that the buyer has to obtain financing. The buyer has until this date to terminate the contract (or request an extension that must be agreed to in writing by the seller); otherwise, the buyer automatically waives the contingency and becomes obligated to purchase the property – even if a loan is not secured.
House Sale Contingency
Although in most cases it is easier to sell before buying another property, the timing and financing don’t always work out that way. A house sale contingency gives buyers a specified amount of time to sell and settle their existing homes in order to finance the new one. This type of contingency protects buyers because, if an existing home doesn’t sell for at least the asking price, the buyer can back out of the contract without legal consequences. House sale contingencies can be difficult on the seller, who may be forced to pass up another offer while waiting for the outcome of the contingency. The seller retains the right to cancel the contract if the buyer’s home is not sold within the specified number of days.
An inspection contingency (also called a “due diligence contingency”) gives the buyer the right to have the home inspected within a specified time period, such as 5-7 days. It protects the buyer, who can cancel the contract or negotiate repairs based on the findings of a professional home inspector. An inspector examines the property’s interior and exterior, including the condition of electrical, finish, plumbing, structural and ventilation elements. The inspector furnishes a report to the buyer detailing any issues discovered during the inspection. Depending on the exact terms of the inspection contingency, the buyer can:
- Approve the report and the deal moves forward
- Disapprove the report and back out of the deal (and have earnest money returned)
- Request time for further inspections if something needs a second look
- Request repairs or concession (if the seller agrees, the deal moves forward; if the seller refuses, the buyer can back out of the deal and have his or her earnest money returned)
A cost of repair contingency is sometimes included in addition to the inspection contingency. This specifies a maximum dollar amount for necessary repairs. If the inspection indicates that repairs will cost more than this dollar amount, the buyer can elect to terminate the contract. In many cases, the cost of repair contingency is based on a certain percentage of the sales price, such as 1-2%.
The kick-out clause is a contingency added by sellers to provide a measure of protection against a house sale contingency. While the seller agrees to a house sale contingency, he or she can add a kick-out clause stating that the seller can continue to market the property. If another qualified buyer steps up, the seller gives the current buyer a specified amount of time (such as 72 hours) to remove the house sale contingency and keep the contract alive; otherwise, the seller can back out of the contract and sell to the new buyer.
The Bottom Line
A real estate contract is a legally enforceable agreement that defines the roles and obligations of each party in a real estate transaction, and contingencies are attached to and made part of contracts. It is important to read and understand your contract, paying attention to all specified dates and deadlines. Because time is of the essence, one day (and one missed deadline) can have a negative - and costly - effect on your real estate transaction.
In certain states, real estate professionals are allowed to prepare contracts and any modifications, including contingency clauses. In other states, however, these documents must be drawn up by licensed attorneys. It is important to follow the laws and regulations of your state. In general, if you are working with a qualified real estate professional, he or she will be able to guide you through the process and make sure that documents are correctly prepared (by an attorney if necessary). If you are not working with an agent or broker, check with an attorney if you have any questions about real estate contracts and contingency clauses.