Home Buyer 101: Appraisal Contingency

Forgive me, friends – I did take last week off. It’s been a busy spring real estate season over here! Today we will cover the appraisal contingency in depth. So let’s start with the basics.

What is an appraisal? Your lender will require that an objective third party (an appraiser) visits the home to assess the value of the property by comparing it to other similar homes nearby that have sold recently. THIS IS THE IMPORTANT PART – Based on the results, your lender will provide a loan based on either the appraised value or the contract sales price, whichever is LOWER.

Let me give you a hypothetical so that you can better understand this concept. Let’s say Bob puts an offer in on a home and it escalates to a final contract sales price of $500,000. The lender then orders an appraisal, and the appraiser determines the market value for the home is only $480,000 based on recent sales. The lender will then only give the buyer the loan based on the $480,000 since it is LOWER. So if bob is planning to put 10% down, the 90% loan will be based off of the $480,000 and not the $500,000. This could leave Bob in a predicament if he hasn’t already thought through this outcome. The bank won’t cover the $20,000 difference, and based upon what decisions he made in his offer regarding his appraisal contingency he may or may not have to come up with this money out of his own pocket in addition to his downpayment and closing costs.

So what does the appraisal contingency entail and how does it protect a buyer? When submitting an offer, you, as the buyer, will get to decide if you’d like to include an appraisal contingency. With this contingency, should the appraisal come in low, you will get the opportunity to renegotiate with the seller on the contract sales price. Just because you have this contingency though doesn’t necessarily mean that the seller has to agree to go lower. If you and the seller aren’t able to reach an agreement you can then back out of the offer entirely, and the seller will likely put his or her home back on the market. That said, a common solution is to meet in the middle – in the hypothetical example with Bob, the seller may agree to come down to $490,000, and Bob will agree to cover the additional $10,000.

As you all probably know by now (if you’ve been following along with my blogs), the DMV is currently a heavy seller’s market so many buyers will have to consider waiving this contingency or get creative and do what I call a “partial waiver.”

Buyers who agree to waive the contingency entirely either need to have a large downpayment or extra funds available in case the appraised value does in fact come back low. When a buyer waives the appraisal contingency entirely, he or she has agreed to proceed with the contract no matter how low the appraisal comes in. In Bob’s hypothetical above, he would need to deliver an extra $20,000 at settlement. One option you, as the buyer, have if you are using a large downpayment is to lower your down payment amount and use the extra funds to cover the amount needed. In Bob’s case, if he was planning to put 20% down he could instead put 16% down and use the extra 4% to cover the difference. This is a common scenario in this competitive market. If you are considering waiving your appraisal contingency entirely, I would encourage you as the buyer to check in with your lender to see what options you have, and to see how much your monthly payment would go up if you did need to use part of your downpayment to cover part of the appraisal differential.

Now, let’s cover the possibility of doing a “partial waiver,” as I like to call it. A lot of my clients are first time home buyers and don’t have the option for a large downpayment (3-5% is pretty typical for first time buyers). In these scenarios, I will ask them to identify how much extra money they could come up with (whether its gift funds from family, pulling from retirement funds or stocks, etc) to put toward an appraisal difference. Once they identify this amount, we will include a term in the contract saying that we will consider the appraisal contingency satisfied if the value comes in below the contract sales price by up to that amount, but if it comes in lower then the appraisal will be in full force in effect. This gives the buyer a chance to renegotiate the price if the difference between the contract sales price and the appraised value is greater than the amount they’ve identified as something they are comfortable with.

One final tidbit of information, if an appraisal comes back higher than the contract sales price then the buyer does not have to disclose the value to the seller and the contract sales price remains unchanged.

Let’s bring this full circle with why the appraisal contingency bares so much weight in an offer. The truth is even if a buyer offers 20% over list price, if he or she includes a full appraisal contingency the escalation is really of no use to the seller considering the appraisal value will likely come in lower. More often than not when a listing agent and seller are reviewing offers, they are going to take careful note of BOTH how high each offer price comes in AND whether or not the appraisal contingency is waived or at least partially waived.

Hope this helps! Will be back next week to talk about condominium association and home owners association documents and the review period.

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