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What Is an Option Contract? - Example & Definition

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  • 0:06 What Is an Option Contract?
  • 2:07 Elements In Real Estate
  • 4:14 Lesson Summary
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Instructor: Kat Kadian-Baumeyer

Kat has a Master of Science in Organizational Leadership and Management and teaches Business courses.

The difference between a contract and an option contract is in the options that a buyer has a right to exercise in the contract, which makes the contract a bit more flexible.

What Is an Option Contract?

Manny visited Speedy's Sports Car Emporium to purchase a shiny new convertible. Manny didn't do much research, so when he learned that the sports car he liked cost upward of $100,000, he knew he would have to secure financing to pay for it.

Manny chose his new set of wheels, and after some hard-nosed negotiations, he was able to convince the calloused car dealer to reduce the price to $99,500. But, he only had $500 to leave as a down-payment while he worked to secure financing. The dealer drafted an option contract that allowed Manny a 72-hour period to secure a loan for the remaining balance.

This option contract allows a buyer and seller to enter into a contract for the sale of goods or real property, but the sale is contingent upon certain terms, like a timeframe or an action. This may be securing financing or passing a home inspection in a real property sale. As implied by the terms, it gives one party an opportunity to buy at a later point in time as specified in the contract. Of course, these terms and other conditions must be written into the contract.

For example, if the buyer does not fulfill his promise to secure the financing by the date specified in the contract, the dealer may keep his deposit. A clause of this nature would have to be written in the contract. If the dealer at Speedy's sells the car to another buyer while under contract with Manny, the dealer may be subject to breach of contract, or not fulfilling the promises of the contract. It should be noted that option contracts are most typically used in real estate transactions and contain all of the elements of a regular contract.

To review, a typical contract contains six elements:

  1. Offer made by the promisor
  2. Acceptance by the promisee
  3. Consideration, or an exchange of one thing of value for another
  4. Mutuality of the parties
  5. Mental or legal capacity to enter into the contract
  6. Legally acceptable terms

An option contract contains all of the same, and a few more, elements.

Elements of an Option Contract in Real Estate

For our purposes, we will focus on an option contract for the purchase of real estate. In an option contract for real estate, the additional elements include:

  1. A contract in writing
  2. The property location specific to the lot and block, sub-division, city, and state
  3. A specific timeframe giving the buyer a period of time to exercise his right to purchase
  4. A final purchase price

An option contract should not be confused with a letter of intent. A letter of intent merely identifies the key understandings between two parties. It is non-binding. An option contract is an enforceable contract and is legally binding.

In a real estate transaction, an option contract benefits the buyer. The seller is obligated to the contract to sell once the offer to sell is made. However, the buyer can get out of the contract for certain reasons that are stated in the contract, like securing financing, or even news of an unfavorable home inspection.

To explain in more detail, if a seller offers to sell a home to a buyer for $150,000, and the buyer needs to secure financing through a mortgage broker, there should be an option in the contract that reflects that the sale of the property to the specific buyer is contingent upon securing financing. If the buyer cannot secure adequate financing for the home in the timeframe stated in the contract, the buyer is no longer obligated to the contract. However, if the seller receives an offer by another during the time the first buyer is working on securing financing, the seller cannot rescind the original offer. He must wait out the time stated in the contract.

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