Second thoughts have poisoned your romance with the house you’ve inked a deal to buy. But what do you do if you’re under contract and your earnest money is on the line?
Earnest money is what’s known as a good-faith deposit that lets the seller know you’re serious about the house and you’re willing to back that up with cash. The amount depends on what you and the seller agree to. It’s usually around 1 to 2 percent of the home price.
However, in a seller’s market, this could be as much as 10 percent. For a $300,000 house, a 2 percent earnest money deposit will run you $6,000. In this example, your $6,000 is at stake if you renege on the agreement — unless you invoke a contingency.
A contingency clause is a condition in a real estate contract that must be met within a certain timeframe for that contract to be binding. The most common contingencies are: appraisal, loan approval and home inspection.
In hot markets, like Seattle, buyers have left off customary contingencies to make their offers more attractive to sellers who may be weighing multiple bids. That practice, however, is less common as the market cools, says Carl Marquardt, a real estate attorney based in Seattle.
“Contingencies are important because they protect the buyer. Otherwise you could end up losing thousands of dollars. Most sellers will compromise on how much of the earnest money they take, but it’s still a risk,” Marquardt says.
Here are some instances when contingencies can help you get out of a purchase contract while protecting your earnest money.
When the home appraisal comes in lower than the asking price
There are several reasons why the sale price might overshoot the appraised value, says Will Arabi, certified residential appraiser and owner of Appraisal Experts of Michigan.
First, you could be in a hot market and buyers are willing to pay more than the appraised price. If this happens, it could take time for the comparables, or comps, to catch up, which appraisals rely heavily on. Comps refer to the sale price of homes in the area that are relatively the same size, condition and with similar features as the one being sold.
“When the market’s jumping, appraisals don’t have time to catch up,” Arabi says. “It could take a good 90 days for properties to close to leave a footprint on the market.”
Another common scenario, explains Arabi, is when your house is bigger or nicer than the surrounding homes. In this case, it can be tough for appraisers to estimate enough value from the additional square footage or amenities.
Buyers who have their heart set on the home can ask for a value rebuttal. Mortgage companies usually have an appraisal dispute process, which might include presenting relevant comps that the appraiser didn’t use. In some instances, the appraiser will make adjustments.
A vast discrepancy — more than 10 percent — is a red flag that your bid is too high or you have a bad appraiser.
“There are bad appraisers. If someone lives 40 miles away from the property, what are the chances they understand the area? The buyer needs to look at why there’s such a big variance and make a determination based on the numbers and facts,” Arabi says.
However, paying a substantial amount more than the asking price can spell trouble if you plan on selling the home sooner than later, says Russell Crary, a real estate agent at Crary Real Estate in Grand Forks, North Dakota.
“I tell my clients to always think about resale, especially if you’re going to live in the house for less than 10 years. The bank will only lend you what it’s appraised for, so you’ll have to come up with the rest of the money,” Crary says. “But if you try to sell the house a few years later and the appraisal is still low, you risk losing that money you put in.”
Here’s where the appraisal contingency can be used to terminate the contract without risking the deposit. Without an appraisal contingency, a buyer might have to make a bigger down payment. If they don’t, they could be in breach of contract and out thousands of dollars.
Scrap the deal if you can’t get financing or you lose your job
The finance or loan contingency is a clause that allows the purchase to be terminated if a buyer can’t come up with financing in a set period. This clause also protects the seller. A homeowner doesn’t want to wait months to sell because a mortgage hasn’t been approved.
On the other hand, without a finance contingency, you can’t just walk away from a deal because financing fell through. In that instance, you would be in danger of losing your earnest money.
Let’s say you were pre-approved for a mortgage with a competitive interest rate, but the lender backed out at the last minute — you could look for financing elsewhere and risk getting approved for a loan with a higher rate or you could exercise the finance contingency clause, back out of the deal and keep your deposit.
The finance contingency can also help buyers who lose their job while under contract terminate the deal, says Michael Mirne, a real estate attorney in New Jersey.
“If the buyer loses their job then the mortgage contingency would fall short,” Mirne says.
When the inspection report reveals major issues
If your dream house turns out to be a house of horrors after the inspector assesses it, you might want to rethink the deal.
Upgrades or additions done without permits should be a warning sign to prospective buyers, says Benjamin Hammond, owner of Magnolia Home Inspections in Nashville.
“If work’s done without permits you have no idea if corners were cut, which could lead to huge problems down the road,” Hammond points out. “Permits require code inspectors. That’s the reason for pulling permits. A code inspector will make sure everything is good.”
Additionally, if an extra room or bathroom was built without the proper permits, a new homebuyer could end up paying for that mistake when they sell the property.
Chicago regulations can make homeowners demolish additions that were built without permits, says Sonia Figueroa, a real estate agent at Century 21 Affiliated in Chicago.
“If a rehabber adds a bathroom and bedroom without permits, and the city finds out later, they will make you tear it all down. The four-bedroom house you bought can become a three-bedroom house overnight,” Figueroa says.
Buyers can find out whether work was permitted by looking at the county assessor’s records, says Robert Knudsen, an attorney in Claremont, California.
While most home inspectors will investigate the permit history for an additional fee, buyers can easily do some upfront investigation themselves. If the county shows that the house is 3,000 square feet but it’s actually 3,800 square feet, it’s possible the additions were done without proper permitting.
Another sign that you might be dealing with illegal work is when it looks shoddy.
“Usually, when an appraiser or inspector notes that work looks substandard then it probably was done without permits,” Knudsen says.
Knudsen points out that, in some cases, permits can be obtained retroactively, however that can get complicated if the work was done years ago.
“Maybe that work (without a permit) was done to code back then but it doesn’t meet today’s standards. You might have to bring it up to code or even tear it down. That can be expensive,” Knudsen says.
Homebuyers should also rethink deals where major structural problems come up or excessive items are reported by the home inspector, Figueroa recommends.
In both cases, homebuyers can use the inspection contingency to pass on the house.
“If big-cost items come up in the report, you want to be able to renegotiate it or move on,” Figueroa says.
Trouble selling your current house
While not as common as the former three contingencies, some buyers will ask for a clause that states that they must sell their existing house for the contract to stand.
Having two mortgages could be a deal-breaker for some homeowners, so negotiating this condition might be an important step in protecting your earnest money.
“I can’t say that this is in the majority of the contracts, but in at least 10 percent of the contracts we do there’s some kind of contingency that states the buyer has to sell their house first,” Mirne says.