Understanding Option Contracts, Option Fees and Option Periods

Let's say you are a Realtor representing a buyer ready to submit an offer on a $500,000 home.  Neither you nor your buyer know anything about the home, but you do know the seller wants $5,000 in earnest money.  How do you ...

• protect your buyer so that he will not have to place significant money at risk on the home before he can do a thorough inspection of the property?

• protect your buyer so that while he is spending money on his inspections, no-one else can buy the home?

• satisfy the seller that there will be a reasonable deadline for your buyer to decide whether they are going to buy the home or not?

The Texas Real Estate Commission Residential Contract handles this dilemma very well.  It simply gives the buyer (for a modest option fee paid to the seller) a short window of time in which to do his inspections without the risk of losing his earnest money or the property being sold to someone else.

When the buyer and seller sign an option contract, the buyer writes two checks.  One check is to the title company and is called the "earnest money".  Click here to learn about earnest money.  The title company holds those funds in escrow throughout the transaction.  We like to see earnest money in the amount of 1% of the negotiated sale price, so this check can be sizeable.  Those funds are not at risk during the option period if the buyer decides not to buy the home during the option period.  The second check is much smaller and is written directly to the seller.  The seller has the right to cash that check immediately, so it is a much smaller amount.  That is called the "option fee".  The option fee and earnest money really work independently of each other.

The buyer can use the option period to conduct his investigations on the property and determine if it meets his needs.  During the option period, the buyer can terminate the contract at any time for any reason whatsoever and the title company has an obligation to return the earnest money to the buyer.  All the buyer has lost is the small option fee and, of course, any money they spent on inspections. 

So how much is an option fee?  That is a negotiable item, but we like to see $100 on homes up to $1 million and $250 on homes over $1 million.  As you can see, the option fee is insignificant when compared to the cost of the home or even the earnest money, but it is meant to be.  Here's why ...

From the seller's standpoint, the non-refundable (to buyer) option fee has to be small enough to encourage the buyer to enter into the contract.   How many buyers would agree to an expensive, non-refundable option fee right up front without having completed the inspections?  Probably not many!

 

From the buyer's standpoint, even though they are going to pay a small, nonrefundable option fee right up front, that fee prevents the seller from selling the home to anyone else during the option period while the buyer is doing their inspections. 

 

How long does an option period last?  They are all across the board.  On commercial or complex land transactions, an option period can last months.  However, unless there are some real issues with a home that requires an inordinate amount of time to resolve, our Realtors like to keep option periods at about 7 to 10 days.  There is no shortage of home inspectors in the Dallas area, so we can always have one out within the next day or two.  If there are questions that just cannot be answered during the option period, the seller may (or may not) agree to extend it, but that is completely up to the seller.  For this reason, we encourage buyers to get right on their inspections as soon as the contract is signed and in the title company. 

Bottom-line ... If you are buying a home, always treat the option period deadlines with respect.  Make sure your negotiations with the seller on repairs (if any) are all hashed out and agreed to in writing before the end of the option period.  

A Tip - At the time of this writing, the Texas Real Estate Commission single family contract states that the option fee must be delivered to the seller (or their agent) within two days of the full execution of the contract.  It is always wise to deliver the option fee check within the two day timeline to the seller or their agent.  And just as importantly, have either of them receipt that they have accepted it.