What are Contingencies and How Do They Affect Your Home Purchase?

Contingency: Another term in the never-ending homebuying dictionary, and one that can sound intimidating, especially if you’re a first-time homebuyer and aren’t really sure what the word means.

A contingency – or contingencies – are qualifications or conditions that must be met in order for a real estate transaction to close. Contingencies are typically requested by the buyer as part of their offer on the home. They essentially mean: “I promise to close on this sale as long as these requirements are satisfied.”

Contingencies can often add more complexity to a sale; however, they definitely have their benefits as their purpose is to protect all of the parties involved in a real estate contract.

In this post, we’ll explain what contingencies are, how they work, why they exist, and how they can affect your home buying process.

What are Contingencies?

Contingencies are conditions included in the contract to buy and sell real estate (contractual clauses) that offer an extra layer of protection for the buyer and seller during the homebuying process. If a contingency isn’t met, the buyer or seller can walk away from the deal.

Contingencies are meant to protect you and your money. When you negotiate your purchase agreement, you as a buyer can ask the sellers for a contingency in regards to almost any concern.

How Do Contingencies Work?

Buyers often add contingencies to their purchase offer in order to protect their good-faith deposit.

Once a seller accepts your purchase offer, typically the buyer must pay a deposit – also referred to as earnest money – that is usually 1% or 2% of the purchase price of the home. A good-faith deposit demonstrates that a buyer is serious about buying the home so that the seller feels comfortable taking it off the market while both parties go through the closing process.

In some states, it is customary to include a small deposit (usually around $500) upon acceptance of the offer and while the purchase and sale agreement is negotiated.

If a buyer defaults on the purchase contract, the seller typically gets to keep their good-faith deposit. However, by adding contingencies to the purchase agreement, buyers give themselves an “out” in the event something negative comes up during the closing process that is irremediable. In such cases, the buyer can void the contract without losing their deposit.

Four Types of Contingencies

Here we will review four types of common contingencies:

1. Appraisal contingency
2. Financing contingency (aka mortgage contingency)
3. Buyer’s old home sale contingency
4. Inspection contingency.

One less common type of contingency is called a title contingency, but we will still cover it at the end. Let’s take an in-depth look.

What is an Appraisal Contingency?

An appraisal contingency is a standard contingency to closing the purchase of a home. That’s because most people need to secure a mortgage loan in order to buy a home. And most mortgage lenders require the home that is under contract to appraise for a value at or above the sale price. This can be done by ordering an appraisal from a third party.

In fact, mortgage companies are so sensitive to home valuations that not only are most lenders prohibited from lending more to a buyer than a home is worth, but their loans are often priced based on how much equity the buyers have in the home (i.e. the amount of cash the borrowers are paying as a percentage of their purchase price). In a nutshell, larger home loans may come with additional costs.

An appraisal contingency clause will include the value that the home needs to meet in addition to the date by which the buyer must notify the seller of any issues with the property’s valuation.

Keep in mind:

• If the buyer fails to notify the seller of any problems, the contingency will be considered “satisfied” and the buyer will be contractually obligated to buy the property.
• If the required valuation isn’t met and the buyer notifies the seller within the specified time frame, the contingency clause will release the buyer from the purchase contract and the buyer will retrieve their good-faith money.

An appraisal contingency clause may also give the buyer the right to go ahead with the sale, regardless of the valuation, as well as the option for the seller to lower the purchase price.

Why Would You Need an Appraisal Contingency?

Here are the functions an appraisal contingency can serve:

• It protects the buyer from buying a home that’s overpriced. Especially in a competitive market, it can be difficult to know whether you’re receiving fair market value for your house or paying too much. An appraisal gives buyers an idea of the market and how much they should pay for a house with their prospective property’s characteristics.
• It protects the mortgage company or a bank from issuing a loan and terms that aren’t appropriate given the value of the house. If you have been pre-approved for a loan, that loan pre-approval was issued based on an assumption of your prospective home’s value. If the appraised value of the home comes in below the purchase price, your lender may not approve your loan at the initial terms that were quoted. This could affect your ability to buy the home.

What Happens If You Receive a Low Appraisal?

If you receive a low appraisal as a buyer and you had an appraisal contingency built into your sales contract, you have the following options:

• You can walk away from the sale (with your good faith money).
• You can get a second opinion and hire another appraisal firm to complete a new report.
• You can offer a larger down payment so that the loan becomes acceptable to the mortgage company.
• Negotiate a lower purchase price with the seller.

Are Appraisal Contingencies Always Necessary?

There are instances when you may not need an appraisal, and those include:

• You’re buying the house with cash, and you are an experienced buyer with a confident understanding of the market.
• You’re planning to significantly renovate the property, and thus, the appraisal isn’t relevant.
• When the seller is offering financing. However, It is still a good idea to order the appraisal to protect the buyer from the seller's fraud.

What is a Financing Contingency?

Also known as a mortgage contingency, a financing contingency is a clause in the purchase contract that states the sale of the house hinges on the buyer securing appropriate financing.

This type of contingency clause will usually state the loan amount, an interest rate ceiling, and the time period the buyer has to secure the loan. The buyer will have until that date to secure an acceptable loan that will enable them to buy the property.

A financing contingency clause typically includes the following information:

• The type of loan the borrower is seeking
• The amount the loan must be for the sale to close
• The maximum interest rate the borrower will accept
• The highest origination points or fees the borrower finds acceptable
• Whether or not financing is dependent upon the sale of another property
• The time frame within which the buyer must secure their financing.

Financing contingencies protect the borrower in the case they can’t find an appropriate loan that will allow them to purchase the property. If buyers have a financing contingency in their purchase contract and they aren’t able to secure the right loan, they may walk away from the deal without penalty, which means they can receive their good-faith money back as long as they notify the seller within the specified timeframe.

If a buyer fails to notify the seller about a financing issue within the specified timeframe, they will still be contractually obligated to complete the purchase.

Are Financing Contingencies Always Necessary?

Instances when a financing contingency isn’t necessary include:

• When the buyer is paying cash for the property
• When the seller is offering financing
• The buyer has already been pre-approved for a loan that will enable them to buy the home and is confident the loan will close.
• The buyer wants to present a strong offer to compete with cash offers from other buyers.

What is a House Sale Contingency?

A house sale contingency says that the buyer’s purchase of the home is dependent upon their ability to sell another property. In other words: The buyer needs the money from the sale of their current home to fund their down payment and potentially other closing costs.

This type of contingency protects the buyer in case they can’t sell their current house for the price they need in order to fund the purchase of the new home. When this happens, the buyer can void the contract and retrieve their earnest money deposit.

House sale contingencies add complexity to home sales because they can involve a chain of buyers who all need to sell their homes in order for the purchase of the next home to close. These contingencies can also be difficult for sellers because they’re being asked to pass on other offers while waiting for their current buyer’s previous home to sell. If the buyer is unable to sell their home within the time specified in the home sale contingency, the seller can cancel the contract.

A home sale contingency typically includes the price at which the buyer must sell their home in order for the sale to close and the time frame they have to do it before the seller can choose to walk away.

What is an Inspection Contingency?

An inspection contingency states the buyer wants to have the home inspected by a professional third party. The contingency will give a specified period of time (usually between 7 and 10 days) during which the inspection must be complete and the buyer must notify the seller of any major issues.

Inspection contingencies may also include a ceiling for the cost of repairs. If the inspection report estimates the cost of repairs will exceed that ceiling, the buyer can walk away from the contract without any repercussions.

An inspection contingency helps to protect the borrower from buying a property with a lot of unknown issues that could be expensive to fix. It also protects the lender from lending on a property that may require a lot of work their borrower isn’t willing to do.

An inspector will typically examine:

• Interior of the home
• Exterior of the home
• Plumbing
• Electrical wiring
• Foundation
• Roof
• HVAC and heating systems
• Structural issues

Once the inspection report comes back, the buyer can review it and take the following actions:

• Accept the report as “satisfactory” and move ahead with the sale.
• Decide there are too many issues and walk away from the purchase (with their good faith deposit).
• Request additional time for further inspection by a specialist (from the seller).
• Request for repairs to be completed by the seller prior to close.
• Request a drop in the contract price or a credit from the seller on closing costs.

You may not need an inspection contingency if the property is new, you’re planning to redevelop the property, or you’re comfortable with taking on any repairs that are needed.

What is a Title Contingency?

A title contingency is less common than the other types we've discussed, but it can make its way into a sales contract if buyers have reasons to believe the title might not come back clean: in other words, the property is free of liens or other issues that could interfere with the transfer of the property. A title contingency can state that the sale of a home is dependent on a clean property title; otherwise the buyer can walk away from the deal without repercussions.

How Do Contingencies Affect the Home Buying Process?

Adding real estate contingencies to a purchase agreement can add complexity to the closing process, and not all sellers are welcome to these stipulations, so it’s important to be judicious when you’re deciding which qualifications you want to make. If you’re struggling to decide what’s really important, your real estate agent or real estate attorney should be able to guide you.

Alternatively, if there are any major concerns you have, including a contingency clause in your purchase agreement can buy you time to find answers to any outstanding questions you may have.

Since contingencies can threaten the sale of a property, sellers may counter a buyer’s contingency request with one of their own: a kick-out clause. A kick-out clause is a seller’s contingency that states the seller can continue to market the property while the buyer completes the necessary process for their own contingency.

If another acceptable buyer submits an offer to buy the house before the current buyer has satisfied their contingencies, the seller can give the contracted buyer a specified amount of time to remove their contingencies or lose the property to the new potential buyers.

The Bottom Line

If you have any questions about the types of contingencies that might be appropriate for your situation, consulting your realtor is always a good start. In addition, OwnUp has a rich library of resources to help guide on your journey to buying your next home.