When you’re working on the computer, the undo button can be an invaluable tool. So can a contingency clause when you’re looking to buy or sell a home.
Contingency clauses provide a way for one or both parties to back out of a real estate contract if certain specified conditions are not met. Common contingencies in real estate include an appraisal contingency, inspection contingency, sale contingency or a funding contingency.
In real estate, a contingency refers to a clause in a real estate purchase agreement specifying an action or requirement that must be met so that the contract can become legally binding. Both the buyer and seller must agree to the terms of each contingency and sign the contract before it becomes binding.
Contingency clauses “safeguard buyers and sellers by giving them the right to cancel a contract if the terms aren’t met,” explains Carlos Del Rio, a real estate attorney in Chicago.
Examples of common contingencies
Many types of contingency clauses can be added to a real estate contract, including:
- Mortgage contingency – This clause specifies a window of time in which the buyer must obtain financing to purchase the home. If the buyer doesn’t secure a loan by that deadline, they can withdraw from the deal without penalty and the seller can put their home back on the market and choose a different buyer.
- Title contingency – This clause “provides the purchaser the right to obtain a title search and raise any objections to the status of the title to the property, which must be cleared by the seller in order for the purchaser to close on the transfer of title,” says Allen Popowitz, chair of the real estate practice at Brach Eichler, a law firm in Roseland, New Jersey.
- Home inspection contingency – This clause involves the window of time the buyer has to get the property they plan to purchase professionally inspected. The home inspection helps ensure there are no serious issues, such as a leaky roof, faulty electrical system or structural defects. “If it turns out the property has defects, and the seller elects not to repair or remediate the issues which are raised by the buyer, the buyer can terminate the contract,” Popowitz says.
- Sale of a prior home contingency – This clause protects buyers who need the cash proceeds from the sale of their existing home to be able to afford a new home. “With this clause, if the buyer needs to sell their current home first by the deadline indicated in the contract, but they cannot find a buyer, they can escape the real estate contract,” says Michael Noker, a Realtor with Realty One of New Mexico in Albuquerque.
- Appraisal contingency – This clause safeguards the buyer by stipulating that the property must appraise for the indicated sales price, at minimum, or the contract can be nullified. This is because banks don’t like to loan money to borrowers for a house that costs more than it’s worth. This clause may also indicate that the seller can opt to reduce the price to the appraised value.
- Homeowners insurance contingency – This clause stipulates that the buyer must apply for and obtain homeowners insurance on the property, and if they can’t get the necessary insurance, either party can withdraw from the contract. This clause is often requested by either the seller or the mortgage lender.
What if a contingency isn’t met?
When a contingency isn’t met, “either party may consider the contract null and void,” Del Rio says. “Doing this allows either party to cancel the deal and pursue other prospects.”
For example, when a property under contract doesn’t appraise for its expected value, the financing for the purchase is put at risk of cancellation.
“Here, the buyer or seller can either choose to cancel the contract, appeal the appraisal or mutually renegotiate the purchase price to accommodate for the [lower] appraised value,” Del Rio says.
Indeed, either or both parties can suggest compromises and reopen negotiations in the hopes of keeping the deal from falling through.
“Say the buyer is unable to get the mortgage loan they need to purchase the property,” Popowitz says. “They would typically have the right to terminate the transaction, but the parties can always agree on additional time for the buyer to continue to pursue other avenues to obtain the loan.”
Contingencies and earnest money
Contingencies are also tied to the earnest money, or “good faith deposit” a buyer often surrenders when going under contract on a home. If a contingency isn’t met, the buyer usually gets that deposit back.
“This earnest money is held in escrow by a third party,” Noker says. “If the buyer defaults on the terms of the real estate contract, the seller gets to keep the earnest money, but if the buyer puts certain contingencies in the contract that allows them to terminate the contract legally, the buyer can have their earnest money refunded to them. In this way, contingencies serve as the emergency escape hatch for buyers.”
Minimum contingencies buyers should include
Homebuyers should always include a financing contingency in their purchase agreement, according to Ralph DiBugnara, president of New York City-headquartered Home Qualified, a digital resource for buyers, sellers and Realtors.
“This is required in almost all states,” DiBugnara says. “With this in place, if your mortgage is denied for any reason, including (a low) appraisal, you have the right to get your deposit money back.”
Del Rio advises adding a homeowners insurance contingency, as well, even if your lender doesn’t require it.
Homebuyers who need to sell their existing home first before buying a new one should also protect themselves with a sale contingency.
“This helps relieve some of the stress that Realtors, attorneys and lenders may have in anticipation of the deal,” Del Rio suggests.
Additionally, don’t skimp on adding a title contingency. You want to make sure the home you’re buying doesn’t have any liens on it and is being sold by the property’s rightful owner.
“This ensures that you’re going to purchase a property that has marketable title without defects that can come back to haunt you,” says Popowitz.
What to consider before adding contingencies
Contingencies offer valuable legal protection, especially to buyers, but you want to be careful not to clutter the contract with too many stipulations, especially in a seller’s market.
“An issue buyers may run into with contingencies is having a less competitive offer,” Noker cautions. “For instance, a seller may choose to accept an offer from someone who has waived a certain contingency.”
Sellers should also be careful not to negatively affect their bargaining position.
“Oftentimes, sellers are so caught up in the joy of selling their home that they tend to shortchange themselves, which can happen if they choose to add contingencies to the contract,” says Del Rio. “I recommend that sellers include language to make the contract ‘as-is’ in nature, which allows the seller to wipe their hands clean and deny any proposals for repairs or closing credit once the closing date arrives.”
Contingencies can protect both the homebuyer and seller, but including too many contingencies in an offer could make the buyer appear less appealing to the seller, especially when multiple offers are involved.
The choice as to which contingencies to include in a contract and the specific terms involved should be considered carefully. That’s where an experienced real estate agent and/or attorney can come in handy. Work closely with these professionals to ensure that you’ll be bargaining from a position of strength, and have a fallback plan in case things don’t go your way.
Courtesy of: Bank Rate