Contingencies and Uncertainties

A purchase offer, which if accepted, becomes a purchase contract, can generally be thought of as the buyer's promise to purchase a property at a specified price under certain conditions. The offer price is the total of the deposit, any increases in downpayment over the course of the escrow and any borrowed funds. The initial deposit, in most cases, is an amount representing roughly 1% to 3% of the purchase price. This money is usually deposited with the escrow holder within two or three days of offer acceptance. When all contingencies have been released, the buyer typically deposits more money in escrow unless the initial deposit is already 3% of the purchase price, which is the maximum amount of "liquidated damages" that the seller can collect in the event of buyer default under California law. The deposit is increased again just before close of escrow by whatever amount is needed to pay the agreed upon price, after taking account of the cash on deposit already, the loan, and any bills and expenses for which the buyer is responsible.

Experienced agents know that contracts with high loan-to-value ratios (big loan, small downpayment) are more likely to unravel than contracts calling for the buyer to have a large downpayment. The rationale is that a buyer that needs a big loan relative to the price is closer to the edge in terms of being able to afford the house. Since sellers pay attention to this, buyers should consider whether their offer would be weakened if structured with a high loan-to-value ratio. Though the seller should, in the end, get the same amount of money whether the loan-to-value (LTV) ratio is low or high, the perception that the value of a high-LTV offer is lower demonstrates one of the key principles in drafting contract terms: people will discount the value of uncertain outcomes, or conversely, people will pay for control.

Recognizing this, the astute buyer does not include a contingency (right to terminate the contract under a specified condition) that he has a very low probability of exercising. Though contracts must be tailored to the specific situation presented by each individual property, there are a small number of common contingency types. One of these is the financing contingency, which allows the buyer not to buy the property without penalty if he is unable to get the loan that he requires. To protect against having to put in a larger-than-anticipated downpayment, the buyer may want an appraisal contingency. These are somewhat more acceptable to sellers than financing contingencies, in that the buyer's right to walk is not triggered by underwriting issues that only pertain to the borrower.

The other contingency most commonly found is one that allows the buyer to reject the property based upon the buyer's determination of its condition. Typically, the buyer will enlist the assistance of structural inspectors and/or specialty contractors to find out if there are any major problems with the property that were not known prior to the offer. This type of contingency is often sufficiently open-ended that the seller has little protection if the buyer simply changes his mind because the buyer's decision about whether the property is acceptable or not is determinative. The seller can often avoid this situation by having a thorough set of inspection reports that enable buyers to evaluate the property's condition without a contingency.

Much in the same way that appraisal contingencies do not weaken an offer as much as financing contingencies, contingencies specific to one subsystem of the house, e.g., the foundation, are perceived as less likely to result in a rescinded contract. Frequently, contracts have some kind of property condition contingency and also an "as-is" addendum. The result is that the buyer can decide not to go forward with the contract, but cannot force the seller to repair discovered defects and sell at the contract price.

Buyers are sometimes confused about the difference in effect between exercising a contingency and defaulting. When the buyer exercises a contingency, which is typically done by giving notice that the contingency will not be released, there is generally no penalty, and the buyer's deposit is returned. The parties are effectively restored to their respective situations prior to making the contract. Default is an entirely different matter. In this case, the buyer fails to perform under the terms of the contract without the protection of a contingency and may be subject to loss of his deposit or liable for additional damages caused to the seller.