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Contingencies in Home Sales:
A Seller's Roadmap to Smooth Closings
Having the house under contract doesn’t guarantee the closing. Whether you are negotiating an agreement or under contract, use this guide to navigate the roads of real estate.
What is a Contingency?
Even though everyone in a contract has signed the papers and has a copy, the buyer of a real estate contract isn’t necessarily obligated to actually purchase the property if there are certain requirements that first must be met. These are called contingencies. The contract stipulates that certain things must happen before obligating the buyer to fulfill his end of the bargain.
Each contingency is a hurdle to be avoided in purchase agreement negotiations or surmounted while under contract.
Earnest Deposit
The first hurdle is the earnest deposit. Every real estate purchase agreement includes an initial down payment toward the property purchase. The seller doesn’t usually get this money, it goes to the title company to hold until closing. This money, held in “escrow,” is a deposit that both the buyer and seller must agree to release to someone if the contract terminates before closing.
In most purchase agreements, the buyer is required to bring in payment to the title company within a specific deadline. If the buyer misses this deadline, the contract is void or voidable.
A good listing agent will counsel sellers to insist on this deadline being short. 24-48 hours is customary. Longer periods of time give the buyer more time to get cold feet or could imply that their finances aren’t particularly strong.
Inspections
It’s reasonable for a buyer to request a whole home inspection before being obligated the purchase the home. An inspection contingency allows the buyer to back out of a contract for any reason. They don’t need to substantiate a specific reason for backing out, it’s the equivalent to a “due diligence period.”
This inspection period typically lasts up to 14 days from the purchase agreement contract date. Within that period, the buyer can provide a notice to accept the property and release the inspection contingency, they can ask the sellers to remedy certain areas of concern, or they can terminate the purchase agreement.
If the buyer doesn’t perform any of those three options, the buyer loses their right to terminate under the inspection contingency.
Financing
In most purchase agreements, there is a section that outlines the kind of financing that the buyer is employing to purchase the home. Sometimes a buyer will mark that the purchase is being made in cash. This doesn’t necessarily mean the buyer is paying actual cash, it just means that they aren’t making the purchase contingent on financing.
If the buyer marks that the purchase is “conditional upon financing,” this means that the buyer needs to borrow funds. Usually the next section of the agreement will stipulate what terms are necessary to get this financing. It will stipulate an interest rate, loan term, type of loan, and loan amount.
All of this means that the purchase is contingent on the buyer acquiring financing under those stipulated terms. If the buyer can’t get the required financing or terms, they aren’t able (or obligated) to purchase the home.
Since every purchase agreement should include a letter from a lender that states their “pre-approval” for financing, an equivalent letter denying their financing would release them from the agreement.
Appraisals
When a home purchase is being financed, the lender will have the home appraised. The lender wants to verify that the home is worth at least as much as the amount being financed. It’s a common misconception that the home must appraise for at least the purchase price for the contract to be valid. That’s not true.
In fact, very few buyer’s agents adequately protect their buyer from short appraisals in the financing section of a purchase agreement.
Without proper protection, if a $200,000 home only appraises for $190,000, the buyer is still obligated the buy the home for $200,000. The short appraisal just means that the bank will treat the home as worth $190,000. It doesn’t necessarily release the buyer’s obligation to close at the higher amount. If the bank is still willing to loan the amount stipulated in the financing section of the contract, the buyer is still obligated to pay the contracted amount.
To properly protect themselves from a short appraisal, a purchase agreement could include a clause that says something like “property must appraise at or above purchase price.” Since this is so blatant a restriction, sellers sometime balk at the phrase. Another, more discreet way to stipulate the same is the specify a loan to value ratio in the financing section.
If a home is being purchased for $100,000, with a 10% down payment, the purchase agreement could stipulate the following in the loan amount section of the financing contingency: “Loan amount of $90,000 with a loan to value ratio of 90%.” This means that if the home appraises at $95,000, the bank will not loan $90,000 at a loan to value of 90%. If the home appraises for $95,000 the bank sees the value as $95,000, and the loan to value would be 94.7% (90/95). Stipulating the loan to value ratio protects the buyer from paying more than appraisal.
As the seller, it might seem like a good thing when a buyer doesn’t protect themself with adequate appraisal language. In cases where the house might not appraise, the uneducated buyer with a sub-par agent won’t take their education willingly when confronted with these facts.
Even though language is missing from a purchase contract that would otherwise protect the buyer, the risk of a low appraisal should encourage a smart seller to insist on explicit language that states “this agreement is not contingent upon an appraisal value equal to or greater than the purchase price.” A little clarity up front avoids a crisis in the end.
Sale Contingency
In many cases, a buyer will need to sell their current home in order to obtain the financing for buying your home. This is called a home sale contingency. In these cases, it’s important to confirm the details of that property being sold. Make sure to know the specific property, when it goes on the market, the sale price, how it looks inside and out.
Do your homework, get your own comps, see how quickly houses sell in that area. Make sure you are comfortable with the property’s prospects to sell, and set a deadline for closing.
In this contingency, your contract is entirely dependent on their house transaction. There are some ways to protect yourself in this situation.
First you could ask for a non-refundable earnest deposit. If the buyer can’t get their home sold and you have to go back on the market, you at lease are reimbursed for your wasted time.
Another option is to leave the house on the market with a right to terminate. The seller can stipulate that they reserve the right to terminate the contract if they get a competing acceptable offer. Keep in mind, these can be hard to get, since your house is technically “pending,” and prospective buyers are usually more hesitant to even view those homes.
In addition, buyers like all the risk of their home not selling to be in the seller’s lap, so a strong, experienced agent is necessary to navigate that process to a safe harbor.
Other Contingencies
The purchase agreement might stipulate other contingencies or certain conditions could be met that allow the buyer to back out. Termites with excessive damage, an insurance claim or excessive house damage while under contract or the discovery of some undisclosed material defect that the seller didn’t disclose can all be reasons to terminate the agreement.
Of course, if the title is clouded or can’t be delivered, it would negate the purchase agreement.
Buyers in Breach
It’s not exactly a smooth road when a buyer backs out of a contract. The first option for a seller when a buyer refuses to close on a property is to sue for performance. This means that you sue the buyer to force them to buy the property. Sound fun?
Now, you might say, that earnest deposit is sitting there at the title company, being held in escrow, and it’s easy to assume that the money is the property of the seller if the buyer backs out of the contract without a valid reason.
However, that title company isn’t the judge and arbiter of who gets the earnest deposit. If there isn’t an express condition in the contract to justify releasing the funds, they won’t decide who to pay without mutual agreement between the buyer and seller or a court order.
If both parties don’t agree on who gets the earnest deposit back. If the amount is small enough, you might take them to small claims court. Or you might need to file suit. In either case, it’s not fun or straightforward and a court needs to decide if the seller can receive the earnest deposit, essentially as damages for the breach of contract.
All of this is to say that when a buyer defaults, unless it is specifically stated that the earnest deposit is non-refundable, the process to cure a buyer in breach is not easy.
Conclusions
Whether you are in negotiations or waiting to close, understanding contingencies is very important. Make sure to work with a realtor who understands the process, can help you avoid potential pitfalls and knows how to overcome the unavoidable obstacles that present themselves. Good Luck!
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