After you’ve bought and sold a house or two, there’s little mystery left to the real estate terms your agent starts throwing around.
- You know the difference between active, contingent and pending listings.
- You know the ins and outs of earnest money, and when you can get it back. (Or at least, when you can try to get it back.)
- You know what can – or should – happen if an appraisal comes back lower than the agreed-upon sales price.
And then you run into this one: an active option contract.
What in the world is that?
Let’s demystify that one, too.
The Basic Home Purchase Process
When you’ve found your dream home, the next step in the process is to make an offer.
You may be the only interested buyer, in which case the seller has only received one offer and simply has to decide whether to accept it, negotiate, or reject it. On the other hand, there may be a number of offers for the house, and the seller has to decide between them before any serious negotiations begin.
Once the seller has agreed to an offer, and the buyer has paid the required amount of earnest money (basically, a deposit), the home’s market status changes from “active” to “contingent.”
“Contingent,” sometimes called “active contingent,” simply means that the buyer has set several conditions on the purchase. Those could be the completion of a home inspection and any repairs which might have to be made as a result, a favorable appraisal, or approval for a mortgage loan. After all contingencies have been met, the status changes from “contingent” to “pending” or “in escrow” and the sale can proceed to closing.
Easy-peasy. Unless you’re in Texas, that is.
Texas is the only state where buyers and sellers use “active option” contracts as a matter of course. That makes things a bit more complicated, but doesn’t change them very much; an active option is essentially the same as a home inspection contingency.
In a few home sales, there are no contingencies; the home is sold “as is.” Once the offer is accepted, the sale is pending and moves through to closing. That’s most likely during a red-hot market, when a buyer wants to be sure that their offer will be the best that the seller receives with no possible roadblocks.
In others there may be contingencies, but not one that requires the satisfactory completion of an inspection and resolution of any problems that are discovered. That happens, but it’s rare (and not a good idea).
In almost all cases, there’s a home inspection contingency. In fact, the vast majority of mortgage lenders require it and the vast majority of realtors (99% of them) recommend it. The National Association of Realtors says that inspections are conducted for 84% of all transactions.
When or if the inspector finds issues with the house (and it’s nearly always “when” rather than “if”), the seller is obligated either to make repairs, or to reach some other agreement with the buyer. That agreement usually comes in the form of a “buyer’s credit,” meaning the sales price is reduced to compensate for the problem(s) found during inspection.
What happens if there are issues that can’t be resolved between buyer and seller? It depends.
The contingency clause customarily specifies a time frame during which the inspection must be conducted, usually somewhere between seven and ten days. If there’s a major structural problem with the home, or the two parties can’t agree on repairs, the buyer has the right to pull out of the sale and have their earnest money returned – if it’s within the specified time frame. If the time frame has expired, it’s unlikely that the buyer can get their earnest money back.
So how does an active option contract change the equation?
The Active Option Contract
In reality, an active option isn’t very different from a contingency clause in a purchase agreement. It’s basically just a different legal way to phrase things.
“Active” means the listing is still on the market; “option” means that a buyer’s offer has been accepted but the deal has not yet been finalized. The buyer pays the seller an extra $100-$200 to buy the option, in addition to the earnest money deposit. In return, the buyer receives the ability to cancel the agreement, for any reason, within a specified time frame of five, seven or ten days.
The reason for the option period is almost always to allow time for a home inspection. Just as with a contingency clause, the buyer can then negotiate with the seller for any necessary repairs, walk away from the purchase, or sign on the dotted line.
If the buyer decides to cancel the deal and it’s within the agreed option period, they can get their earnest money back. If the decision to back out comes after the option period has expired, the seller keeps the earnest money. In either case, the seller retains the option payment. Why? In effect, that payment was made in return for extra time to think about the purchase, so the buyer has no claim on that money. It was a separate transaction.
There’s one extra twist, though. Since the listing is still “active,” the seller can continue to show the home to other potential buyers and receive other offers. However, the seller can’t accept any of those offers until and unless the agreement with the original buyer crashes and burns. Any offers they receive during the option period are strictly “backups” and can’t be acted on unless the house is legally available for sale once again – even if the backup offers are better than the original one. If the first buyer backs out of the deal, the seller can decide between the backup offers as if the original offer never happened.
Why Would a Buyer or Seller Want an Active Option Contract?
You’ll usually only see active option contracts in Texas, and it’s for a very good reason: state law requires it in most cases. This quirk was part of the state’s standardization of home inspection procedures.
If a buyer wants some time to evaluate a property, negotiate after an inspection, and be able to back out of the deal, that can’t be done in Texas with a contingency clause. It can only happen when the parties sign an active option contract. It’s as simple as that.
Active option contracts seldom fall through; only about 3% of potential buyers back out of the deal before the option period is over. That’s about the same number of home purchases that fall apart through an inspection contingency clause.
Even so, it’s the smart move to pay a couple of hundred dollars for an active option contract in Texas, or to establish an inspection contingency in other states, when buying a house. Unless you decide to buy a house as-is to ensure that your offer will be accepted by a seller, having an escape hatch available is simply common sense.
Active Option Contract FAQ
Q: Is an active option contract better than a home inspection contingency clause?
A: They effectively accomplish the same thing, but in Texas, the only way to get a home inspection contingency is through an active option contract.
Q: Which one should I choose?
A: It’s unlikely you’ll have the choice. The active option will cost a small amount of money, while a contingency clause is “free” to add to a contract. But the route that’s available to you will depend on the state where you’re buying a home. It’s not an either-or issue.
Q: Are there pros and cons to making an offer on a home that’s in the active option period?
A: The advantage is that you might get a second chance at a house you really want, if your first offer wasn’t initially accepted. The disadvantage is that you’ll have to wait a week or two before you know whether the home is even back on the market; that could be a problem if you find another house you want to buy while your “backup” offer is on hold.
Q: Can you only back out of an active option contract because of problems with an inspection?
A: No, you can cancel the purchase for any reason during the option period. To be fair, though, lots of sellers in other states have invoked their inspection contingency clause to cancel a deal after “suddenly discovering” a “serious” issue with the home – when they’re really just gotten cold feet or found an even better house to buy instead.