Today I’m going to tell you everything you need to know about real estate contingencies.
Here’s what you’ll learn :
- The meaning of contingency in real estate
- Difference between contingent and pending
- Most common contingencies with examples
- How contingencies can ruin a home sale
Let’s dive in.
What does contingency mean in real estate?
A contingency is certain criteria in a real estate contract that needs to be met before the sale can be final. Almost all contingencies in a real estate contract will be from the buyer, but they can come from the seller too.
Think of contingencies as clauses in the contract.
When a buyer makes a contingent offer on a house, they’re essentially saying, “I’d like to purchase the home, but I want to make sure some things are finalized on my end before closing the sale.”
There are different types of contingencies in a real estate offer and each of them has a big impact on determining if the sale closes or not. I’ll tell you how shortly.
An offer on a house that includes one or more contingencies is called a contingent offer.
A non contingent offer is an offer on a house that does not include any contingencies.
Imagine you’re selling your home.
Would you rather have a buyer give you an offer with clauses in the contract or an offer without any clauses?
This is why you’ll see a lot of non contingent offers in a hot real estate market where buyers are competing with each other.
When a buyer makes a non contingent offer, they need to acknowledge they’re removing all contingencies.
Here’s what that looks like in a California real estate contract.
Contingent offers are more common.
When a buyer includes any type of contingency in their offer, they need to remove it before the closing date.
This happens on an addendum to the real estate contract called a contingency removal form. Here’s what that looks like.
Contingencies play a big role in a real estate transaction.
The buyer’s good faith deposit is at risk once the buyer removes their contingencies.
Shortly after a purchase agreement is ratified, the buyer will make a deposit to the escrow company This is referred to as a good faith deposit or an escrow deposit.
The buyer risks losing this deposit to the seller should they want to back out of the sale after removing their contingencies.
From the seller’s point of view, having the buyer remove their contingencies is a big hurdle to cross as it means the buyer is more committed. This is why a non contingent offer is more attractive to a seller.
Contingent vs Pending
Have you seen contingent or pending on a real estate listing before?
They look like this.
The difference between the two?
Contingent means there are contingencies that still need to be removed before the sale can close.
A pending real estate listing means there are no contingencies.
A real estate sale will go through four different “statuses”.
- Active – The property is currently for sale.
- Contingent – The seller has accepted an offer but the buyer has not yet removed their contingencies (also referred to as active contingent).
- Pending – The buyer removed their contingencies.
- Sold – The sale is final and has recorded in the county where the property resides.
When you see a status change of contingent to pending or active contingent to pending, it means the seller’s agent received the contingency removal from the buyer.
You’ll see the status of a real estate listing change after the seller’s agent updates the listing in their local MLS (multiple listing service).
What are common contingencies included in the purchase agreement?
Now that you know the definition of contingent and what contingencies are, let’s discuss the ones you’ll probably hear about the most.
A real estate transaction can consist of any type of contingency, but there are four that are more common than others.
- Inspection contingency
- Appraisal contingency
- Loan contingency
- Home sale contingency
It’s not just the type of contingency that is important, it’s the contingency period too.
A contingency period is the number of days that a buyer has before they need to remove that specific contingency. The lower the number of days is, the more attractive it looks to the seller.
If the buyer doesn’t remove the contingency by the end of the contingency period, then they risk having the seller cancel the transaction.
When most people hear of an inspection contingency, they think of a home inspection contingency. While a home inspection is the most common inspection for a buyer, there are other inspections they might want to have done.
Here are a few of the more common ones:
- Termite inspection
- Roof inspection
- Pool inspection
- Chimney inspection
- Foundation inspection
An inspection contingency doesn’t mean a buyer is only allowed to do inspections. This contingency period allows them to do any and all due diligence on the property that they want.
Maybe they’re thinking of remodeling and want to bring a contractor out to the property. Or maybe the home has previous structural modifications and they want to check on the permits.
No matter what it is, this is the time for the buyer to finish doing their homework on the property.
What if a seller has inspections done upfront?
A seller has the option to have their own inspections completed before putting the home on the market. When they do, it not only allows them to know what they might need to have fixed ahead of time, but it also gives prospective buyers more information about the property to help them make a more informed decision about what kind of offer they want to submit.
A good analogy for this is buying a car.
When you go to the dealership and shop for a used car, they’ll usually have a Carfax or something similar. This information is helpful because, without it, buyers may be hesitant about making an offer.
Well, it’s the same thing when buying a house but at a much higher price.
When a seller has inspections completed upfront, it improves the chances of a buyer not including an inspection contingency in their offer.
But it doesn’t mean they can’t.
Similar to someone buying a car and having a mechanic look at it when the dealership has a Carfax, many homebuyers will still want to do their own inspections.
Inspection contingency example
Let’s say a buyer included a 14-day inspection contingency in their offer and decided to have a home inspection completed.
The buyer’s agent helps coordinate the inspection and the report comes back on day 9. After going through the report with their agent, the buyer feels there are a couple of items that need to be addressed.
In this scenario, the buyer has three choices:
- Ask the seller to repair the items
- Negotiate with the seller to fix some of the items and/or reduce the sale price
- Do nothing and remove their inspection contingency
The location and type of market will have an effect on what the buyer decides to do. In a neutral or buyer’s market, the buyer has more leverage, and sellers are more willing to negotiate or repair the items.
If the buyer wants to ask the seller to repair the items, they need to have their agent send over a repair request.
This request is made on an addendum to the real estate contract.
When the seller’s agent receives this request, the seller can decide whether or not they want to make the repairs.
So in our scenario, let’s say the buyer’s agent sent the repair request on day 11. The seller’s agent discusses it with the seller and they decide to go ahead and have the items repaired.
When this happens, the inspection contingency will be extended until the work is done. Once the work is completed, the buyer will submit a contingency removal form to the seller and their inspection contingency will be released.
What if the seller didn’t want to fix the items?
Then the buyer has a decision to make.
They can either try and negotiate to have some of the items repaired or have the work done themselves after the sale closes.
If the contingency removal isn’t submitted by day 14, then the seller has the option to send what’s called a notice to perform. A notice to perform tells the buyer that if they don’t remove their contingencies within a certain number of days (usually 1-2), then the seller can cancel the contract.
An appraisal contingency is a clause in the real estate contract that allows the buyer to back out of the transaction if the appraised value does not meet the purchase price.
The contingency period for an appraisal is the time frame the buyer has to not only have their appraisal completed but more importantly, signed off by their lender’s underwriter.
When a buyer gets a loan, the house is used as collateral, and an appraisal is proof of that collateral. This is why every lender requires an appraisal for a real estate transaction. They want to make sure that the house is worth at least what the buyer is paying for it.
The appraisal is ordered by the buyer’s loan officer shortly after the contract is ratified. When the appraiser goes out to the property, they are aware of the sale price and will need to justify that price in the appraisal report by comparing the property to recently sold homes (also known as “comps”).
In many purchase transactions, the appraised value will match the sale price. When this happens, the buyer will remove the contingency by submitting an appraisal contingency removal.
But what happens when the appraisal is lower than the sale price?
Let’s find out.
Appraisal contingency example
A buyer and seller have agreed to a sale price of $1,200,000.
The appraisal comes back at $1,150,000.
What happens now?
Well, the buyer has three options:
- Renegotiate the price
- Pay the difference
- Back out of the transaction
In a neutral market or a buyer’s market (more buyers than homes for sale), sometimes the buyer can renegotiate the price.
But remember, they have a contingency that allows them to back out of the transaction (and get their deposit back) if the appraised value does not meet the sale price. And some buyers will do this.
In a competitive market where there’s high demand, many buyers will pay the difference. Here’s where many people get confused; the buyer doesn’t actually pay the entire difference.
How to calculate the down payment when the appraisal comes in lower than the sale price
Banks will use the sale price or the appraised value, whichever is lower.
So, in our example, the buyer and seller agreed upon a $1,200,000 purchase price and the appraised value came in at $1,150,000.
This means the lender will lend on the $1,150,000 amount and not $1,200,000. In this scenario, the buyer does not pay the full difference of $50,000.
If the buyer planned on putting 20% down on $1,200,000, that means they planned on a $240,000 down payment.
Since the appraised value came in at $1,150,000, this means the buyer will now need to pay 20% of $1,150,000 (which is $230,000) plus the difference of $50,000. This means that the down payment will now be $280,000.
In other words, if the appraisal comes in lower than the sale price, then the buyer will pay 80% of the difference between the appraised value and the sale price, and not the entire 100%.
How an appraisal contingency can affect the seller
An appraisal contingency doesn’t just have an impact on the buyer, it affects the seller too.
Let’s say you’re selling your house and you get a non contingent offer at a phenomenal price.
You’re ecstatic, right?
What if the appraisal comes in lower than the sale price and the buyer doesn’t have the funds to pay the difference?
You are either going to have to lower the sale price or cancel the transaction and put the house back on the market.
How do you prevent this from happening?
Make sure your agent vets the buyer upfront.
When interviewing real estate agents, you’ll want to make sure they know how to vet an offer. By doing so, they can find out how much money the buyer has and can explain the pros and cons of accepting an offer when the buyer doesn’t have additional funds should the appraisal come in lower than the sale price.
We’ve seen scenarios where a seller has received two or more offers and they choose one with a lower offer price because the buyer had a larger down payment.
A loan contingency, also known as a mortgage contingency, is a clause in the real estate contract that allows the buyer to cancel the sale if they are not able to get financing. The loan contingency period is the time frame a buyer has to make sure they’re fully approved for the loan.
Most buyers will get a pre-approval letter from their lender before they make an offer on a home. A pre-approval letter is a great start but most pre-approval letters are not actual loan approvals.
When the buyer’s offer gets accepted, their loan officer will gather all of the necessary documents and send them to the underwriter to start the underwriting process. Once the underwriter looks over the documents, they’ll decide if they should issue a conditional loan approval or not.
It’s rare for a loan to not get approved if the buyer has a pre-approval letter from a good loan officer, but it does happen. When it does, and if the buyer included a loan contingency in their offer, they’re able to back out of the transaction and get their deposit back.
In most cases, the buyer will remove their loan contingency after they receive their loan approval. They need to submit their loan contingency removal before the contingency period expires or risk having the seller cancel the sale.
Sale of home contingency
Many sellers will ask if they should even accept an offer that includes a sale of home contingency.
If you have an experienced and savvy realtor, it can actually work in your favor. I’ll explain shortly.
When a buyer needs to sell their house before they’re able to purchase a new one, they’ll include a contingency on the sale of their home.
In some states (e.g. California), this is simply known as a home sale contingency and there is one addendum to the real estate contract.
In other states, there are two different types of home sale contingencies:
- Sale and settlement contingencies
- Settlement contingency
This is what the home sale contingency addendum looks like in California.
No matter the state, a home sale contingency operates in a similar capacity.
Sale and settlement contingency
A buyer will include a sale and settlement contingency when they have not accepted an offer on their home.
This usually happens when the buyer doesn’t want to be in a time crunch and make an offer on a home after their home is in escrow.
As a seller, getting an offer with a sale and settlement contingency can seem daunting.
And it can be. Instead of worrying about one buyer being able to close, you now have to worry about two. Plus, the time to close is going to be much longer than the average transaction.
Most sellers who accept an offer with this contingency will do so because their home has been on the market for some time.
But if a seller is working with an agent who knows how to negotiate, they can use a sale and settlement contingency to their advantage.
First, the buyer is getting the ideal scenario with this type of offer. They’re playing it safe and waiting to put their home on the market until they have a ratified contract on their new purchase. Plus, they have fewer homes to choose from as many sellers won’t accept an offer with this contingency.
Because of this, the agent should be able to negotiate a higher price.
Second, a sale and settlement contingency allows the seller to accept a backup offer and “kick” the buyer out if they don’t remove their contingency within a certain timeframe (usually 1-3 days).
A great agent will use this to their advantage and market the property accordingly.
What is a kick out clause?
A kick out clause allows the seller to kick the buyer out of the transaction if they receive a backup offer that does not include a sale and settlement contingency.
When a seller receives the backup offer, they can notify the buyer and request that they remove the contingency.
If the buyer doesn’t remove it, then the seller can accept the backup offer (buyer gets their deposit back).
Here’s how the language in the California real estate contract reads for a kick out clause.
If you’re a buyer, you need to be aware of how a kick out clause can affect you and assume that the seller’s agent will be marketing the property to get another interested buyer. This means you’re going to want to get your home ready to sell as soon as possible.
As a seller, you want your agent to be aggressive and see if they can attract a better offer.
Sometimes, just changing the status from active to contingent will spark more interest from buyers. When a home has been on the market longer than usual (common for homes that accept a sale and settlement contingency), buyers start to question why.
Once the status has changed, it shows that there was someone else interested and that there’s an opportunity for a new buyer to take advantage.
A settlement contingency is when the buyer has a ratified contract on their current residence but have not yet closed.
This contingency protects the buyer in case their sale falls through.
Many sellers are more receptive to this contingency.
How buyers should prepare a home sale contingency
If you’re thinking of submitting an offer with a home sale contingency, you’re going to want to make your offer look as best as possible.
And I’m not talking about price and terms.
Of course, these are important, but a contingency on the sale of your home is going to be a concern to the seller.
You want to reduce their concern.
This can be done by including a one-page word doc with your offer that details nearby sales that support your list price and your plan to go to market.
You’ll want your agent to show recent sales of homes that are similar to yours that support your asking price. This is key.
A good listing agent will vet your offer thoroughly and part of that will be checking on recent sales close to your home to make sure they support your price. If your list price is higher than the supporting comps, your offer is going to look much less appealing.
Contingencies in real estate can have a big impact on the sale.
Price is almost always most important to both the buyer and seller, but contingencies come in a close second.
When the buyer removes their contingencies, they are fully committed and the chances of the sale closing dramatically increase.
As a buyer, contingencies protect you from losing your good faith deposit and allow you to do further due diligence on the property. It’s imperative you understand how each of them works before submitting an offer.
For sellers, it’s important that you work with a realtor who knows what to watch out for, how to vet the buyer, and is an expert at negotiating. If you’re thinking of selling, you can find top realtors who fit these criteria at SoldNest. We find and vet top realtors in your area who give a cash credit toward pre-listing services and improvements.