Contingency Clauses in Home Purchase Contracts

A loan contingency clause in a contract defines a condition that must be met or an action that must be taken before a sales agreement becomes binding.

A home loan contingency clause commonly gives the buyer the right to have the home independently appraised, to have the home professionally inspected, and to obtain a mortgage.

Finalization of the contract is contingent on those conditions being met in a satisfactory manner.

How Real Estate Transactions Work

But first, a quick review of how real estate transactions work. A real estate transaction typically begins with a proposal: A buyer presents a purchase offer to a seller, who can either accept or reject it. 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 1% or 2% of the sale price. The funds are held by an escrow company while the closing process begins.

Real Estate Contingencies

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 time frame (for example, “the buyer has 14 days to inspect the property”) and specific terms (such as, “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 written and outlined clearly enough for all parties to understand the terms.

Contingency clauses can be written for nearly any need or concern. But in every case, 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 they decided to back out.

The consequences of being in breach of contract 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 a specific performance, forcing the buyer to purchase the home.

Appraisal Contingency

An appraisal contingency protects the buyer and helps ensure a property is valued at a specified minimum amount. If the property does not appraise for at least the specified amount, the contract can be terminated, and in many cases, the earnest money 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 certain 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.

Financing Contingency

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 from the contract and reclaim their earnest money in the event they are unable to secure financing from a bank, mortgage broker, or another type of lender.

A financial contingency will state a specified number of days the buyer is given 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.

Home Sale Contingency

Although it is easier to sell one home before buying another property in most cases, the timing and financing don’t always work out that way. A home sale contingency gives the buyer a specified amount of time to sell and settle their existing home 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.

Inspection Contingency

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 five to seven 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, back out of the deal, and have the earnest money returned
• Request time for further inspections if something needs a second look
• Request repairs or a concession (if the seller agrees, the deal moves forward; if the seller refuses, the buyer can back out of the deal and have their 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 home 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% or 2%.

Kick-Out Clause

The kick-out clause is a contingency sellers add to provide a measure of protection against a house sale contingency. Though the seller agrees to a house sale contingency, they 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.

Risks of Contingencies

The biggest risk with including contingencies in your offer is that the seller may not accept them or they may be too restrictive to allow you to back out. If you are in a housing market where your offer may be competing with other offers, consult with your real estate agent to determine what contingencies to include.

In some hot housing markets, some buyers are even excluding appraisal contingencies from their offers in order to get their offer accepted. This is a risky option to take because buyers will be responsible for coming up with the cash to split the difference if the property doesn’t appraise for enough.

Challenges of Contingencies

Contingencies offer their own challenges within real estate contracts. They can frequently become an additional source of stress for both sellers and buyers. If a buyer can’t get a home inspected by the home inspection contingency deadline, they must decide whether to move forward before the home inspection is complete or try to extend the deadline and therefore the closing date. If a seller is depending on the sale of their home to be completed on time before they can move, then extensions of contingency deadlines can jeopardize their plans.

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. Contingencies are clauses attached to and made part of the contract. 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.