Real estate has long been the go-to investment for those looking to build long-term wealth for generations. Let us help you navigate this asset class by signing up for our comprehensive real estate investing guide.
Sometimes it can seem like real estate has a language of its own. If you're not familiar with buying and selling properties, odds are good that you're probably wondering, "What are contingencies, and how will they affect my transaction?" If so, you're not alone. Many people have asked the same question.
To that end, below is a primer on the basics of contingencies. In this post, we'll cover what they are and how they work in a real estate deal as well as some examples of a few contingencies that are commonly used when buying or selling a house. Learn everything you need to know about contingencies before entering into the real estate market.
What are contingencies?
In real estate, contingencies are conditions written into the purchase agreement. Though contingencies are mainly utilized by buyers, both the buyer and seller have the option to include any contingencies that they would like in the contract. However, once they've been agreed upon by both parties, they must be properly satisfied in order for the transaction to continue moving forward.
After all of the contingencies outlined in the agreement have been fulfilled, the sale can be finalized. But, if the requirements of a contingency cannot be met, both parties must either agree to renegotiate or walk away from the real estate transaction. At that point, the buyer would be free to look for another home and the seller would be allowed to put the home back on the market.
Why use contingencies in real estate?
Put simply, it's a good idea to include contingency clauses in a real estate contract because they provide a safety net, especially as the buyer. As stated above, if a contingency cannot properly resolved, both parties have the option of walking away from the sale. In the buyer's case, they're able do so with their earnest money deposit in hand.
That said, there is also such a thing as using too many contingencies. Since contingencies effectively give buyers a way out of the contract, sellers often see them as a liability. An offer that includes many contingencies is often seen as being weaker than an offer without them and may end up getting passed over if there are other options available.
Why are contingencies important?
Contingencies are important because they ensure that all of the necessary pieces of the contract fall into place before settlement. Since all contingencies have a time frame in which they need to be fulfilled, they also ensure that the various components of the transaction keep moving forward in a timely manner.
With that in mind, when you're buying a home, it's absolutely crucial to stay on top of any contingencies you've included in the purchase agreement, as well as their respective timelines. As long as you fulfill the terms of the contract within the specified timeframe, your earnest money deposit is not at risk.
If, however, you do not fulfil your obligations in a timely manner, you'll be in breach of contract. At that point, if you choose to walk away from the deal, the seller is technically entitled to your deposit money.
Common types of contingencies
Now that it's clear how contingencies work in real estate, we'll explore the various types of contingencies. Below are five of the most common types of contingencies that you might see in a real estate contract. Read them over so you can get a sense of what they cover and how they are used.
The inspection contingency is probably the one buyers know the most about. As the name suggests, this contingency allows buyers to perform any inspections on the real estate investment that they see fit. After the inspections have been completed, it also allows them to negotiate any suggested repairs or remediation with the seller.
Most buyers assume that this contingency simply covers the home inspection, which entails a general inspection of the property's condition, as well as its major systems like the HVAC system and plumbing. In reality, though, there are multiple inspections that buyers can elect to perform on a home, including:
- Wood-destroying insect inspection.
- Radon inspection.
- Mold inspection.
- Lead-based paint.
- Structural damage.
Bear in mind that you likely won't need to elect all of the available inspections for your new home. However, at the end of the day, it's a matter of choosing the ones that make you feel most comfortable moving forward with your purchase.
If you're planning on using a mortgage to cover the cost of buying your home, you're going to want to elect the financing contingency. This contingency allows you time to apply for and become approved for your mortgage. It also states that, if for some reason you're unable to be approved for a mortgage, you're no longer contractually obligated to buy the property.
Many buyers, especially first-time homebuyers, have a tendency to assume that once they've received a preapproval, they're guaranteed a loan. Unfortunately, though, that is not the case. Rather, getting a preapproval is just the start of the loan application process.
Once you've received a preapproval, you still need to apply for the loan and go through the underwriting process. During the underwriting process, underwriters will take an in-depth look at your financials, including your income, debts, and assets. If they find any red flags that they're unable to clear up, they reserve the right to deny your loan application, at which point you could use the financing contingency.
For the most part, the financing contingency and appraisal contingency go hand in hand. In fact, receiving a satisfactory appraisal is usually one of the conditions that needs to be fulfilled in order to be approved for a loan.
After all, an appraisal helps determine the fair market value of a home, and, since the bank wants to ensure that they're making a good investment, they won't close on a mortgage that's worth more than the home's value.
If an appraisal comes back lower than the proposed purchase price, the appraisal contingency gives you the opportunity to renegotiate it. If the seller is open to renegotiation, you might end up getting a better deal on your home purchase. However, if an agreement can't be reached, electing this contingency will allow you to walk away from the purchase unscathed.
Home sale contingency
Even though it's not used as often anymore, the home sale contingency is still worth mentioning. This contingency is used when buyers need to sell their current home in order to be able to purchase a new one. It allows the buyers a specified amount of time to find a buyer for their current home. Otherwise, they have the freedom to walk away from the purchase with their deposit intact.
As you might be able to imagine, this clause isn't very popular among sellers. After all, in the above scenario, they're left taking their homes off the market with little to no reassurance that their buyer will actually be able to purchase the home. To that end, it's best used with caution, especially if there are other offers on the table.
A kick-out clause is essentially a contingency for the seller. It's most often used in conjunction with home sale contingencies. This clause states that even though the sellers have an offer in hand, they still have the right to continue to market their home.
If they find another buyer, they have to notify their buyer and give them 72 hours to pull the appropriate financing together. If the original buyer is unable to come up with the proper financing to purchase the home, the sellers are free to move forward with the new buyer instead.
The bottom line
Put simply, contingencies are an important part of any real estate transaction. On the one hand, they're there to make sure that the various parts of the transaction keep moving forward until they can all come together. On the other, they offer both parties protection in the event that mutually beneficial terms cannot be reached.
Whether you're buying or selling a home, you'll want to make sure that you understand any and all contingencies that have been included in your purchase agreement. Have your real estate agent guide you through the terms of the contract, as well as your responsibilities, before you agree to anything in writing.
11% of the mega-wealthy swear by this investment…
The richest in the world have made their fortunes in many ways, but there is one common thread for many of them: They made real estate a core part of their investment strategy. Of all the ways the ultra-rich made their fortunes, real estate outpaced every other method 3 to 1.
If you, too, want to invest like the wealthiest in the world, we have a complete guide on what you need to take your first steps. Take the first step toward building real wealth by getting your free copy today. Simply click here to receive your free guide.