Common Real Estate Contract Provisions, Part 1

Common Real Estate Contract Provisions, Part 1

            While the basics of real estate agreements and sales are covered in other presentations, this presentation will focus on common clauses in real estate contracts. We will discuss the natures of the clauses and their purposes. In the text below this video, we are including a link to a sample contract with these clauses (and more) included. So please feel free to review this for context.[1] This presentation will cover three of the most important real estate contract provisions and another presentation will cover several more.

Earnest Money and Forfeiture by Breach

            Real estate sales contracts call for a specified amount to be paid at the time of the signing of the agreement, with the remaining due at closing. This amount, known as “earnest money,” is also sometimes referred to as a “down payment,” though it should not be confused with the “down payment” that mortgagors pay in addition to the amount of their mortgage loan, to complete the payment.

The amount of the earnest money can vary widely, and while the National Association of Realtors says to expect a down payment of one to 2% of the purchase price,[2] many contracts call for earnest money of 10% or more.

            The earnest money is typically held by an escrow agent (often one of the attorneys handling the transaction) from the time that the contract is executed through closing, at which time the earnest money is given to the seller as part of the purchase price. 

Aside from the fact that this money cannot be used by either party between contract and closing, the amount of the earnest money is critical because many real estate contracts call for the earnest money to be forfeited if the buyer inexcusably fails to complete the purchase. 

The earnest money, then, serves not only as an indication that the buyer is serious, but also protects the seller. In reliance of the contract, the seller typically takes the property off the market and stop trying to sell it elsewhere. If the buyer breaches the agreement, precisely measuring the damage caused to the seller because of this reliance is all but impossible. Therefore, the earnest money creates at least some level of certainty by providing the seller with compensation if the buyer breaches.

Conversely, it also provides the buyer with cost certainty as the buyer may later decide that forfeiting the down payment is an acceptable cost to get out of the transaction. For example, let’s say the buyer pays $10,000 in earnest money on a $300,000 house. The buyer may later find a comparable house for $275,000. It makes economic sense in such a case for the purchaser to simply breach the initial contract, forfeiting the $10,000 in earnest money, and purchase the second house. This maneuver is sometimes known as an “efficient breach” [3] and that is not discouraged under contract law.

Marketable Title Defined

            The responsibility to provide “marketable” title is a fundamental duty of the seller in any real estate transaction. While the term “marketable” can be defined using caselaw and other precedent, the contract can also define “marketable” with respect to its transaction. A typical provision defines marketable title as title that a title insurance company is willing to underwrite and insure. If the title company is willing, after an appropriate title search, to insure title, which means that it will compensate the purchaser for any damages caused by defects in the title (usually, mortgages or liens that were previously in force and never satisfied), then the title is self-evidently marketable.

Mortgage Contingency

            A mortgage contingency clause makes the contract conditional on the purchaser securing a mortgage (as described in the agreement) within a specified time after the contract’s execution. Though purchasers can obtain “preapproval” letters that indicate that they’re likely qualified for the mortgage they need, most banks will not give final approval to a mortgage application unless the potential borrower can produce a signed sales contract. Moreover, the approval process often requires appraisals, inspections, title searches and various other steps that would be too cumbersome and expensive without the certainty of a signed contract. Though purchasers normally expect, in good faith, that they will be able to secure the mortgages they need, they naturally don’t want to lose their down payments should their mortgage applications fail for whatever reasons.

            The mortgage contingency clause may state, for example, that unless the purchaser secures a mortgage for 80% of the purchase price within 45 days after the contract is signed, either party can terminate the agreement, in which case the purchaser gets his earnest money back. The provision typically requires the purchaser to make a good faith attempt to comply with all the requirements necessary to secure mortgage approval. This clause allows the purchaser to avoid the risk of losing his down payment if his mortgage application fails through no fault of his own. The timeframe limitation also allows the seller to cut her losses and move on to the next potential purchaser if she sees that the purchaser is having trouble obtaining a mortgage.

            Naturally, sellers prefer contracts without mortgage contingency clauses (sometimes referred to as “cash” transactions) because they eliminate this uncertainty. In fact, sellers are often willing to accept slightly lower offers if they do not require contractual mortgage contingencies.

            Our next video, a continuation of this presentation, covers the basics of five additional common real estate contract clauses.