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In today’s hot real estate market, the temptation to make a big offer to win a bidding war is real.
But it might backfire.
You could be in a sticky situation if your offer ends up being higher than what the home is appraised for. In such a scenario, you might have to pay more out of pocket to close the deal.
That’s where an appraisal contingency comes in. An appraisal contingency gives you the ability to back out of a real estate sales contract if the home’s appraised value is less than your offer. This type of contingency has extra significance this year: Rising home prices have created a seller’s market, in which sellers are more selective with buyers—and contingencies can make a purchase offer less attractive.
That’s why an increasing number of buyers are waiving appraisal contingencies right now, says Jamie Owen, certified real estate appraiser and owner of Cleveland-based Aspen Appraisal Services. “It seems to be primarily due, at least in part, to the severe shortage of [housing] inventory, with many homes having multiple offers.”
Desperate buyers may be waiving the appraisal contingency more frequently, but Owen says it’s probably not wise. If you agree to buy a property for more than what it appraises for, you’ll have a tougher time getting a mortgage without renegotiating the sale price.
Without an appraisal contingency, you could be in breach of contract if you can’t complete the purchase. In that scenario, you could lose your initial deposit that typically accompanies an offer letter, which is usually 1%-3% of the sale price or $3,000-$9,000 for an average home.
What Is a Home Appraisal and When Is It Required?
A home appraisal is done by a certified real estate appraiser to determine the value of a property. An appraisal isn’t the same thing as a home inspection, which focuses more on the condition of a house as opposed to its overall value.
The appraisal is more visual and the home inspection is more operational, says Joseph J. Zoppi, managing partner at New Jersey based Templar Real Estate. An appraiser typically only takes the condition of home into account when it impacts the value, like a leaky roof.
Appraisers rely heavily on the recent sale of comparable homes in the same area, known as comps or comparable sales. The standard home appraisal is almost always based on comps, Zoppi says. In some circumstances, like with unique properties or apartments, an appraiser may consider the cost to replace the building or its rental income when determining its value.
If you’re taking out a mortgage to buy a home, the lender is almost always going to require an appraisal. However, if you’re refinancing your current mortgage you may be able to skip the appraisal depending on the mortgage type and how much equity you have in your home.
Appraisal standards are more strict for some government-backed mortgages, like Federal Housing Administration (FHA) loans. There are things appraisers don’t have to include in a report for a conventional loan that are required for an FHA loan, Owen says.
What Is an Appraisal Contingency?
When a buyer makes a purchase offer on a home, the contract will include more than just the price and details of the property. Typically, it will also contain stipulations that must be met for the sale to be finalized.
Even if you included an appraisal contingency in the purchase contract, you can still negotiate with the seller to drop the price if the appraised value is lower than what you agreed to pay.
Common real estate contingencies apply to findings from the home inspection, financing, and the appraisal. For example, If you lose your job and no longer qualify for a mortgage, a financing contingency lets you walk away from the deal with no penalty.
When your offer to buy is more than a home is appraised for, that’s when an appraisal contingency comes into play.
For example, if you agree to buy a home for $200,000 but the appraised value comes in at only $190,000, the lender isn’t likely to give you a loan for the property unless you find a way to cover the difference. Typically, in this situation the difference is covered by either the buyer paying more or the seller lowering the price, or some combination of the two.
An appraisal contingency protects you in this circumstance. If you can’t find a way to work around the low appraisal, it allows you to cancel the deal without being in breach of contract.
Should I Waive the Appraisal Contingency?
Real estate contingencies typically protect the buyer, so sometimes purchase contracts with fewer contingencies can be more appealing to a seller. Every extra stipulation added to a contract is one more potential hangup to completing the sale.
Having a sales contract terminated because of appraisal issues is rare, and accounted for less than 1% of real estate transactions last month, according to a Next Advisor analysis of an August 2020 National Association of Realtors survey. But without an appraisal contingency, you could be in breach of contract if you can’t complete the deal because of a low appraisal, and you could lose your earnest money deposit.
Earnest money is an escrow deposit the buyer makes after an offer is accepted, and it’s usually 1%-3% of the purchase price. This money shows the seller the buyer is committed. If everything goes smoothly, the earnest money deposit will go toward closing costs or the down payment.
But if the appraisal is low, and you waived the appraisal contingency, you lose your earnest money if you can’t complete the sale. That’s why even in today’s hot real estate market, only around 20% of winning home offers waive the appraisal contingency, according to Redfin.
You should only consider waiving the appraisal contingency if you’ve talked with your real estate agent and feel strongly that you’ll need to waive it to get your offer accepted or it’s very unlikely for the appraisal to come in low. Even in that case, it’s also best to have extra cash on hand so you can bring more money to the table to make up the difference in case the appraisal is lower than expected.
What Can I Do If the House Appraises for Less Than the Offer Price?
While it’s not an ideal situation, appraisers sometimes determine a house isn’t worth the agreed-upon price. But remember: everyone involved in the transaction wants the sale to happen. So there are ways to work through it and finish the deal.
This is where having an appraisal contingency gives you more options. If you have the ability to walk away from the deal, the seller may be more willing to negotiate. With a low appraisal the best scenario for the buyer is to negotiate with the seller to reduce the sale price to match the appraised value.
You can also continue with the sale as is, but it’s likely you’ll have to pay the difference in the sale price and appraised value, or risk being turned down for a home loan. One common compromise is to meet the seller in the middle, by paying more up front and with the seller accepting less than the original offer price.
For example, if the appraisal finds a house is worth $5,000 less than the offer was accepted for, the buyer might pay $2,500 more and the seller might accept $2,500 less. This way the bank still pays the same amount, but the actual deal reflects the difference between offer price and appraisal value.
Before any negotiations take place, you should talk with your real estate agent about the possibility of asking the lender for a second appraisal. This isn’t a common option, but in some cases it is warranted. To get a second appraisal you’d have to prove the first appraisal wasn’t adequate, Owen says. You’d have to show there was some kind of incompetence in the original appraiser’s work, he said.