Hello everybody, it's Sam from the Financial Samurai Podcast. And in this episode, I wanna talk about buying a home with contingencies, whether it's financing contingencies or home inspection contingencies. There are actually many types of contingencies. And the reason why I am talking about this specific topic is because I think it was overlooked as one of my posts.

Maybe it's summertime or maybe I just didn't write the post insightful and entertaining enough. But this is one of the most important posts you can read if you're looking to buy a home ever, okay? Ever, I'm not just talking about right now, but ever. For most people, I think they go into a home and buy it with contingencies.

But for me, I haven't bought a home with contingencies in I would say the past three homes. So that's a long time. The last time I bought a home with contingencies was my very first home because I didn't really know what to look for. But now that I've remodeled, gut remodeled multiple homes before, I've met with multiple inspectors, plumbing, electrical, building, and city inspectors.

I know what to look for when buying a home. Therefore, having a home inspection contingency is not as necessary in a competitive market. Now, markets turn, real estate cycles go up and down. And currently, there's a lull on the coast, at least here in San Francisco. And so I'm trying to take advantage and upgrade homes because I love real estate.

I love to enjoy the house that I live in and potentially make money. I think it's the best usage of your funds. Whereas stocks, yeah, it goes up, but then it goes down. You never really gain any utility. So I'm in the process of buying a home and I was able to get into contract with a contingency, a home inspection contingency.

And it's very eye-opening for me because I haven't written about this in the past and I wanna help you think as a real estate investor how you can really profit when you have a contingency. All right, once your offer is accepted with a contingency, you must send an earnest money deposit equal to one to 3% of the value of the home to an escrow company.

This is to protect both parties. The escrow company holds the money until all contract conditions are met on both sides. And please know before wiring any money, call the escrow company and confirm the wiring instruction before sending. I've seen horror stories about folks wiring money to wrong accounts because the emails, the emails were getting intercepted by some hacker.

So just be careful, call ahead, confirm, confirm, confirm. And then contingencies are conditions written in your real estate offer letter to protect yourself from losing your earnest money deposit. It's usually about 3% earnest money deposit. So for example, if for some reason the bank decides not to lend you money, if you have a financing contingency, you have a penalty free out.

So in other words, you can not buy the home and you can get all your 3% or whatever percent earnest money deposit back. Now let's say you have a home inspection contingency and you find during your due diligence, there's a leak, a damaged part of the roof and the seller isn't willing to fix it or pay for it or negotiate a lower price.

Well, you have the option, penalty free, of withdrawing your offer and getting your earnest money deposit back. Such contingencies have expiration dates, note that. And when that date comes, the prospective buyer must sign a document that releases the contingencies. It's not a, oh, we got to that date, it automatically expires, the earnest money deposit is mine if you don't buy it.

No, no, no, no. You have to look at the document and sign. It's usually a docusign, electric signature, where you say, I release contingencies. So then after that, your earnest money deposit is at risk. Therefore, it is vital, vital, vital that before you release any contingencies, you get all your ducks in order, you do your due diligence thoroughly.

So obviously from a home seller's perspective, they prefer not to have any contingencies in the offer, no financing, no home inspection contingencies. In a hot market, they could afford that. People just wanted to get in. And if you offered contingencies, well, it made your offer uncompetitive. But now, finally, if you've been renting all these years, if you've been waiting for the right time to buy, well, because mortgage rates are averaging, supposedly 7% for an average 30-year fixed, the demand has waned because affordability has decreased.

7%, it's not super high in a historical context. I remember getting a 6.5% mortgage rate in, what's that, 2003, 2004, 2005. I thought I was fine. And home prices still went up before, of course, the 2008, 2009 crash. But from a historical perspective, mortgage rates are not high. But from a recency perspective, given we could have all refinanced under 3% for a 30-year fixed, it does feel high.

So demand is softer in some regions of the country, most notably on the West Coast. And so, therefore, homebuyers have an opportunity to buy if they have the down payment or if they have a lot of cash to pay cash, all cash for a home. Now, why do I say buying a home with contingencies is like getting a free call option?

Well, call options are financial contracts that give the option buyer the right but not the obligation to buy a stock, a bond, a commodity, or other asset at a specified price within a specific time period. A call buyer profits when the underlying asset increases in price. And in this case, this podcast episode, the underlying asset is a house.

And I want you to click over to the post, and you can just see a chart that highlights how you make money through buying a call option. Once you send in your earnest money deposit and get your offer accepted with contingencies, you don't have much downside risk at all until the contingencies are removed.

You now have the free call option to buy the property at an agreed upon price at no cost to you. You're in escrow period, right? And the average escrow period is something around 30 to 45 days. But I've seen it go to 90 days or even longer. At the same time, you have the upside profit potential as time goes on.

Time here is a huge variable in a call option. So in order to potentially make the most money off a home as possible, you want to have as long of an escrow period as possible. So that's time. To do so, one strategy is to input long contingency durations. And then another strategy is to extend the escrow period as many times as possible.

So now you're asking, well, why? Why is the free call option more valuable the longer the contingency duration, the longer the escrow period? Well, it's because the more time you have, the more time you get to make a more informed home buying decision. So imagine getting into contract to buy $1 million worth of the S&P 500 index at a strike price of $4,500.

If the contract lasts only 30 days, that's not a lot of time. You wouldn't be willing to pay a lot for that contract to buy $1 million worth of the S&P 500 index. I calculate maybe it's worth $8,000, or 0.8% of the value of the purchasing power. All right, now, let's say you have a call option to buy $1 million of the S&P 500 index at a strike price of $4,500, but the duration is 10 years.

You have 10 years to decide whether you want to buy $1 million at $4,500. At a 7.2% annual rate of return, the S&P will have doubled in 10 years. So that $1 million will have gone to $2 million. Hence, the value of the contract is much greater than the previous example of $8,000, because it only lasted 30 days.

With a 10-year option, you might be willing to pay $500,000, $600,000, $700,000 to have the option to buy $1 million at $4,500, because the probability, based on historical returns, 7.2%, it's kind of in the realm. And if it's below that, well, you can calculate your break-even cost. And if it's above that, you're going to make a lot more money.

So you can extend this type of thinking to buying a home. Let's say you put down a $30,000 earnest money deposit to buy a $1 million home, 3% earnest money deposit. The contingency duration is 45 days for buyer's investigations. And after the contingency duration expires, you then have another 15 days to come up with all the funds to close, because that's what's written for the close of escrow target date.

Now, without an extension, the total escrow period is 60 days. Now, let's say during this 60-day process-- or let's just say 45-day process for the contingencies-- that there's peace in Ukraine. In addition, the federal government announces it's going to do another quantitative easing for some reason with a surprise $3 million stimulus package to create more jobs.

After all, it's election year coming up. You've got to buy your votes, right? So due to these two factors, the S&P 500 rises by 10%. 10% in 60 days is huge. That's a raging bull market. Now, with a lot more wealth created in the economy during this 45- to 60-day period, the value of your home might have appreciated by another 3%.

Now, if that's the case, you absolutely want to buy that house. It's a free call option to buy it at 3% below market value. Now, let's look at it the other way. During the 45-day contingency period, let's say China decides to invade Taiwan. In addition, a major employer near the house's neighborhood you want to buy decides to shut down, and 5,000 jobs are lost.

As a result, the S&P 500 declines by 20% during this 45-day contingency period. In this situation, the value of your house may have depreciated by 5% to 7%, or $50,000 to $70,000 on a million-dollar house. So what are you going to do now? Well, if you choose not to drop your contingencies, you can walk away.

You can also negotiate for a lower purchase price. There are no standard contingencies for exogenous variables like war, although you could write one into the contract. Anything is negotiable. But if you have a contingency in your offer, you can always find an excuse not to move forward, not to buy the house, or not to pay the price you agreed upon.

Everything is negotiable. These examples should help illustrate, from a financial perspective, why sellers want faster closes and why buyers should want longer closes. The more time a buyer has to survey market conditions, the more ammunition buyers have to make an optimal home purchase decision. Now, technically, there is some opportunity cost after sending in your earnest money deposit to get into contract.

That opportunity cost is the income or returns you could have made if you had invested down payment instead. And with rates at 5-plus percent, that opportunity cost is significant for a large down payment. Some states do require escrow to pay an interest on the earnest money deposit, but the rates are very low.

I checked here in San Francisco, California, and escrow is required to pay something like 0.1%. So who cares? That is a PITA. Although there is minimum financial downside risk if you make an offer with contingencies, there's also the cost of your time and the added stress you may feel in buying a home.

So if you're not one to like contract negotiations, negotiating, making people sweat, and dashing your dreams and hope, well, this sort of buying strategy, of buying with contingencies and extending and negotiating, isn't going to be very pleasant. But if you're like me, who loves to write about real estate, who loves to buy real estate, who loves to get a good deal, and who loves to understand the various strategies involved to help y'all, listeners and readers, get a better real estate deal for yourself, well then, this to me is a goldmine process that I love.

Let me share a real life example of my escrow process. Back in April 2020, I stumbled across my primary residence. It was listed, I think it was in mid-April, right? And I said, "Wow, this is a great house. "Panoramic ocean views on all three floors, "nice space, good for work from home.

"What a great house, I wanna buy it." And I talked to the listing agent over a course of maybe five sessions, private sessions, 12 hours, and we developed a working relationship. And ultimately, I let him represent me through dual agency. And he really fought for me. It was pretty amazing, because he convinced the seller to go with my offer, which was $100,000 lower than a competing offer, for various reasons too.

And so I got into contract, and I just realized I did have a contingency. I had a financing contingency. And the financing contingency was that I would get financed by a bank for the rest of the payment of the house. I put down, I think it was 40%, and I financed 60%.

And that was a strong down payment that went in my favor. And I was going with a big bank, which also went in my favor. So the seller was like, "Oh, big bank, "you got a good down payment. "We're gonna go with you, not this other potential buyer." So we got into contract in June, beginning in June 2020, and it was a 30-day close.

30 days is reasonable if you have financing contingency. And about the last week of the 30-day close, I started to get cold feet, because if you can recall, June 2020, things were still under lockdown. Things were still uncertain. I think many of us hoped we would have one week, two week lockdown, maybe one or two or three months max, but not April, May, June, third month of lockdown, right?

So I was thinking to myself, man, is this the right move to spend more money on a home we don't really need, although we were going through a gut me remodel process with our existing home on the downstairs floor? Is this a good idea to spend this much money on a home while we're still under lockdown?

And so I said, "Well, let me see if I can extend escrow." So essentially, that's what I did for another 30 days, because I wanted to buy myself time to get the right financing, but also to see if the stock market and the economy recover and if the government would step in.

And so every single week, the market started rebounding after, what was it, March 18 meltdown, right, for 30 days. And then after that, so at the end of April and then May, June, things started to recover, especially since the government stepped in with their bazookas with economic stimulus. So this time, buying more time gave me more confidence to buy this house.

And as a result, it ended up being a optimal, or at least a good financial decision, because home prices increased since mid 2020. So if you're planning to buy a house in this lull, I would suggest buying one with a contingency and have the longest contingency possible. You need to calculate the probabilities of a couple things as well.

One is the probability the home will close by a certain date, your escrow closing date. And then two, the probability of you actually purchasing the home. If you're like me, you like to look at a lot of properties. You sometimes spray and pray and make offers on overpriced or underpriced properties.

You never know unless you give an offer and you see what happens, right? I've seen many homes sell for below what I thought. And I was kicking myself thinking, man, I should have put an offer on the home for a competitive price. Anyway, the reason why you need to calculate your probabilities of when the home will close and whether you will actually purchase the home is because you've got to figure out how you're gonna invest your down payment.

For most people, your down payment is your sacred down payment. If it's 20%, you should probably have the vast majority of it in cash. 80 to 100%. But for other folks who like to take a little bit more risk, you can have some of it in liquid stocks, index funds, whatever it is you want.

It just depends on your risk tolerance. Because the higher the probability you plan to buy the home, the lower the percentage of your down payment money should go to risk assets. And then vice versa. If you think there's only like a 20% probability you're gonna buy the home because the seller has to go through a lot of hoops due to the contingency as well, you can invest more like you normally would with your money.

After all, let's say 2023, S&P 500 is up 20%. You don't want to just be twiddling your thumbs and having it all cash while the market is up so much. You would miss out on a lot, especially if you're paying all cash for a home. So these are some things to think about as you manage to buy a home with contingencies.

The more stocks and other risk assets go up for your down payment fund, the cheaper the home and vice versa. Don't forget to calculate your future cash flow as well as how many other assets you can move around in terms of shifting assets from stocks or other investments to buying your home.

The more assets you have, obviously, the more risk you can take on the down payment of your home. Alrighty, folks, I hope you enjoyed this episode. It really helps if you can think about buying a home like an investor with a lot of money at stake. Yes, we mostly buy homes to enjoy, create memories, raise our children, take care of our parents and our family members, but let's be frank here.

A home is likely the most expensive asset you will buy in your life. So it behooves you to think like a rational, savvy investor. And this is part of the reason why I'm recording this podcast. It's actually the main reason why. I don't want y'all to lose money on a home.

I want y'all to enjoy your home and make money in the future. Thanks so much, everyone, for listening. If you'd like to subscribe, check out financialsamurai.com/news. Over 60,000 of you have subscribed to my newsletter. So this way you never miss a thing. And please share, rate and review this podcast.

I'm just a one man band, but I'm trying to help you guys succeed because financial independence is worth it. Take care.