What is a Contingency?
Contingencies are an escape plan, like a fire escape, if something goes irreparably wrong during escrow. Before writing an offer, buyers sometimes become quite macabre, and start thinking up doomsday scenarios about their deepest home buying fears coming true. What if the roof leaks? What if there is an earthquake during escrow and the property is destroyed? Do I still have to buy it? What if I lose my job and can’t qualify for a loan? What if the property doesn’t appraise?
Why are Contingencies Important?
As long as there is even (1) one contingency, the buyer may cancel the transaction for the contingency reason and have their earnest money deposit returned. Once all contingencies are removed, if the buyer doesn’t close- the seller may keep the buyer’s deposit as liquidated damages- OUCH!
There are THREE standard Contingencies in the Purchase Agreement: The Inspection Contingency, The Appraisal Contingency, and The Loan Contingency.
1.) Inspection Contingency – 17 Days
The inspection contingency protects the buyer if there are defects in the condition of the property, like a bad foundation, termite damage, sewer line replacement etc. During the inspection contingency, this is the time in escrow where a buyer hires a professional inspector to evaluate the property. If the buyer finds a big problem they can either cancel the deal or try to work out an agreement with the seller with a request for repairs.
The Inspection contingency is the broadest contingency. There are no precedents for what the buyer may or may not find “satisfactory” in regards to the condition of the property. The buyer is not even required to hire an expert, they can find the property unsatisfactory from their own inspection. The inspection contingency becomes even more broad to apply not only to the physical condition of the property but also “and any other matters affecting the property”.
Most realtors (including myself), tell our buyers “as long as you have your inspection contingency in effect, you can cancel for any reason”. You are supposed to exercise this contingency in good faith and have a legitimate reason to cancel – but there is no test for good faith or punishment to enforce it even if it isn’t acting in good faith (one reason for bad faith- another property came on the market that I like better). Cancel for any reason? Not exactly a comforting thought for sellers. Many a seller has lost a nights sleep over the inspection contingency. Understandably, sellers are always anxious to remove it.
In Buyer’s markets, the inspection contingency is the standard 17 days which is plenty of time to complete all investigations of the property. Remember, some of the buyer’s investigations depend on information provided by or obtained by the seller, so if the seller drags their feet on providing their disclosures (TDS, SPQ, Prelim), ordering the city 9A report, or ordering HOA Docs for condos, this can make the inspection contingency late. Once a buyer receives a disclosure they have a couple of days to review it.
In Sellers Markets, where multiple offers are common, sellers can improve the terms of the sale by reducing the number of days for the inspection contingency. They usually want 10-14 days (but sometimes they even try to chop it down to 7!). 10 days is just barely enough time to get everything done. Keep in mind, most inspectors don’t book inspections on Saturday or Sunday, and they are booked a few days in advance. Couple that with the fact that they need a day or two to write their inspection report and you have already spent 4-5 days.
If the buyer’s inspection turns up a problem that requires following up with a professional or specialist, and you will need more time for follow up inspections. Anything less than 10 days, is very short and will be very difficult to complete on time. If the seller as for less than 10, hopeful they have some presale inspection reports to provide the buyer to give them a head start.
Expert tip: If you know you are going to have a short inspection contingency (because the counter offer says so), book an inspection before you respond with your best and final and have an accepted offer. That way you don’t waste the first few days of escrow if your offer is accepted. If you offer is not accepted, you can cancel the inspection that you prebooked. As a courtesy to my inspectors, I tell them I am doing this.
2.) Appraisal Contingency – 17 Days
For buyers getting a loan to buy a property, they will want an appraisal contingency to go along with their loan contingency. Lenders will complete an appraisal in the first week or two of escrow. If the appraisal comes in for less than the accepted offer amount- then that can be a problem. You can always request for the bank to do another appraisal, or ask for a reconsideration of value, but in my experience appraisers rarely change their value- and if they do, it is only by a very small amount. In my experience, it is easier to switch lenders and start the loan process all over again, then it is to get a higher appraisal!
Let’s suppose you are in escrow for $500,000 planning to put 20% down, which is $100,000 and the appraisal comes back at $460,000 and now there is a $40,000 gap. There are a few things that can happen: 1)The seller can lower the purchase price to the appraisal price and everything is fine. Buyers will argue that if the bank says the property is only worth $460,000 – it’s only worth $460,000 and why should they pay more? 2) If the buyer wants to buy the property regardless of the low appraisal, the buyer can come up the difference. The Bank is still willing to loan on a value of $460,000. The buyer could stay with 20% down and on the $500,000 purchase price the bank will loan $368,000 on the $460,000 value, and the 20% down payment is $92,000- which the buyer adds the $40,000 difference so that they are now putting $132,000 down (if the buyer has the cash to bring to the deal). If the buyer doesn’t have the cash, they could change the financing and put less down so that they have more cash to pay the seller. They could change from a 20% down loan to 10% down, then the bank lends $414,000 and buyers downpayment is $46,000 instead of $92,000, and they use the extra 10% just to pay the seller- a negative to the buyer will have PMI if under 20% down or 3) the buyer and seller can try to negotiate the difference and if they can’t come to an agreement cancel. Whatever happens, the appraisal contingency protects the buyer if the appraisal comes in short.
1.) Loan Contingency – 21 Days
- CAR Purchase Contract 3. (J) 3
If the buyer needs a loan to purchase the property and the bank denies them, this contingency allows the buyer to cancel at no fault. In Sellers Markets financing loosens and loans move quick. I have several lenders now who can approve buyers (DU approval) before they even write an offer! In Buyers Markets, or with big banks with lots of red tape, getting loan approval can take 25 days or more. Loans are being done in 30 days now, but just a few years ago they were taking 45 days as the banks were really scrutinizing every detail. This contingency takes the longest, and is usually removed right before closing.
With Loan contingencies, you can specify a maximum interest rate that a buyer is willing to pay.
I hardly ever fill this out, but you should, because it protects buyers from a sudden increase in interest rate. If you leave it blank the interest rate is just assumed to be prevailing market rates. Let’s say the interest rate is 4%, you usually pad the current interest rate an acceptable amount, maybe 4.25% or 4.5%, because rates do change. If the rate shot up overnight to 6% or something, the buyer would not be obligated to take such a higher interest rate loan than what they intended.
A: In the old days, contingencies were removed by passive removal. Passive removal means contingencies were automatically removed when the contingency expiration date written into the purchase agreement lapsed. As you can imagine, this led to many lawsuits!
Today contingencies are removed by active removal. To remove a contingency or contingencies the buyer must do so in WRITING by signing a Contingency Removal form. It’s one page. As long as the contingency removal form has NOT be signed, the contingency remains in effect, even if the contingency period of 17 days or whatever it was in the contract has passed. You can remove contingencies one at a time, or remove all contingencies except a specific contingency, or remove ALL CONTINGENCIES with this form.