Real Estate Jeopardy Time: “Most purchase agreements are contingent on which two items?”
Answer: Financing Contingency and Inspection Contingency
Most purchase agreements are contingent on financing and inspection contingencies. These are the two primary ways a buyer can back out of the purchase agreement and cancel the sale. But first, what is a contingency in a real estate contract?
What is a Contingency in a Real Estate Contract?
When asking the question, “most purchase agreements are contingent on which two items?” we must first understand what a contingency is as it relates to a purchase and sale agreement. In simple terms, a contingency is a condition that must be met in order for the purchase agreement to become binding. Typically, the condition must be met within a specific period of time. If for some reason the condition is not met, the party unable to meet the condition could cancel the contract.
Most Purchase Agreements Are Contingent on Which Two Items?
FINANCING AND INSPECTION CONTINGENCIES. Just want to make sure you are paying attention 😃
Let’s take a closer look at both of these contingencies and break them down further.
Financing Contingency in Purchase Agreement
While many investors pay cash for real estate, most home buyers will need obtain financing when purchasing a home. This means they need to be pre-approved by a qualified lender, then meet all lender requirements during the escrow period and close on the loan.
Lenders look at many criteria when pre-qualifying a buyer. Employment status, credit score, credit history and debt-to-income ratio all play a role on what type of loan a borrower will qualify for. Most conventional loans require at least a 5-20% down payment. There are government backed loans such as FHA and VA loans that require less than 5% down. FHA and VA loans are seen as riskier loans by lenders and therefore require the borrower and (sometimes) the property to meet specific criteria before closing on the loan.
In other words, many lenders have their own contingencies that the borrower must meet before closing on the loan. In addition to meeting these requirements, the bank will also order an appraisal on the property to verify the value. This is another condition altogether. This makes a financed offer a much riskier offer than a cash offer.
What can go wrong with a financed offer?
Even though a buyer might be pre-approved by a lender, there is always a chance the loan will not close. Here are a few examples of why loans fall apart during the escrow period.
- Change in employment status: If there is any change in employment status such as loss of job, change of job, change in rate of pay, etc the loan will likely not close.
- Appraisal comes in too low: This is really another contingency altogether, but if the buyer is paying cash, there is no appraisal. When there is a lender involved, the bank will order an appraisal to confirm value of the property they are lending against. If the appraisal comes back too low, the buyer may cancel the agreement.
- Borrower is unable to come up with enough cash to close: Just because the borrower had enough cash at one point, doesn’t mean they won’t spend that money during the escrow period. If the buyer can’t come up with the required “cash to close” the loan will not close and the sale could be canceled.
- Documentation not provided: During the lending process, the borrower is required to provide documentation of all finances. If for some reason the borrower is unable to provide the requested documentation, the loan may not close.
Inspection Contingency in Real Estate Contract
Another common contingency in a real estate contract is the inspection contingency. This contingency allows the the buyer to inspect the physical characteristics of the property, usually within a given timeframe. Most buyers elect to hire a professional to conduct the inspection. The inspector will evaluate the condition of all mechanicals, structural integrity, electrical systems, plumbing, HVAC, cosmetics such as floor condition, evidence of water damage, termites, etc. If the buyer is not satisfied with the inspection results, the buyer can back out of the sales agreement or renegotiate.
It’s common for sellers to use the inspection contingency to get a better price. This is more common with older homes that have lots of deferred maintenance.
The problem with the inspection contingency is it’s very subjective and it essentially gives the buyer an easy out. For example, let’s say the inspection report came back with only minor repairs. If the buyer suddenly gets buyer’s remorse, they could use the inspection contingency to back out of the contract. In this case, the seller wouldn’t have much recourse.
In a seller’s market, it’s common for aggressive buyers to waive the inspection period. It’s also common for cash buyers and investors to waive the inspection period, especially when getting a great deal.
So, let’s refresh. Most purchase agreements are contingent on which two items? Financing contingency and inspection contingency. These are the two most common contingencies, but there are many other contingencies that buyers and sellers should be aware of.
Other Contingencies in a Real Estate Purchase & Sale Agreement
There is no question financing and inspection contingencies are the two most common contingencies you will see in a purchase agreement. However, there could be a myriad of other contingencies that a buyer or seller could elect to put into the purchase agreement. Let’s explore some other common and less common contingencies.
Appraisal contingency: We already discussed the appraisal as being part of the financing contingency. If the appraisal comes back lower than the purchase, most lenders will provide a loan unless the borrower can come up with enough cash to cover the difference. Unless the contract has an appraisal gap clause, the buyer can ask to renegotiate or back out of the sale.
Contingent on sale of home: Occasionally, a buyer will make purchase agreement contingent on the sale of their home. This is more common in a buyer’s market when there is plenty of inventory and homes are sitting on the market for weeks at a time. If the buyer cannot sell their home within a certain timeframe they could back out.
Title contingency: Almost all purchase agreements will have a title contingency. In other words, the seller must provide clear title and any liens, judgements, etc must be taken care of before closing. The title company will run a title search and the seller usually pays for the owners policy (title insurance) to insure title. If there are any defects or the seller is unable to provide clear title, the buyer can cancel the agreement. In most cases, the buyer will delay closing until any title issues are sorted out.
So, there you have it. These are the most common contingencies you will see in a purchase agreement. Financed buyers usually have the most contingencies. Cash buyers and investors usually have the fewest contingencies. Contingencies are always negotiable so don’t be afraid to negotiate!
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