An appraisal contingency is a clause in a real estate contract that protects buyers by allowing them to back out of the deal if the home appraises for less than the agreed-upon purchase price. Essentially, it’s a safeguard that ensures buyers don’t overpay for a property while reassuring lenders that the home’s value justifies the loan amount.
When you purchase a home, especially with a mortgage, the lender requires an independent third-party appraisal to assess the home’s market value. This appraisal helps determine how much the lender is willing to lend. If the appraisal comes back lower than the sale price, the lender may only approve a loan for the appraised value, leaving the buyer responsible for covering the difference out-of-pocket.
With an appraisal contingency in place, the buyer has several options if the appraisal is lower than the purchase price. They can either renegotiate the price with the seller, walk away from the deal, or adjust their financing. Without an appraisal contingency, the buyer is still legally bound to purchase the home at the agreed price, even if the home’s value doesn’t match. In this case, the buyer risks losing their earnest money deposit and could face legal consequences if they back out.
Why Is an Appraisal Contingency Important?
An appraisal contingency is a critical safeguard in real estate transactions, offering buyers protection in various ways. It ensures that buyers are not financially obligated to move forward with a deal if the property’s appraised value falls below the agreed purchase price, preventing them from overpaying and facing potential financial consequences. Below are the main reasons why this contingency is so important.
Prevents Overpaying for a Home
The primary purpose of an appraisal contingency is to protect buyers from paying more than a home is worth. An appraisal assesses the home’s fair market value by considering its condition, location, and recent comparable sales. Without this contingency, buyers could find themselves locked into paying a price higher than the home’s appraised value, leading to negative equity, where the buyer owes more than the property is worth. This scenario can be particularly problematic if home prices fall after the purchase, leaving the buyer with a property that isn’t worth the amount they paid.
Protects the Buyer’s Earnest Money Deposit
An earnest money deposit shows the seller that a buyer is serious about the offer, but it’s also a risk for the buyer. Without an appraisal contingency, if the home appraises for less than the purchase price, the buyer may be required to move forward with the deal or lose their earnest money deposit. The contingency provides peace of mind by allowing the buyer to back out of the agreement without forfeiting this deposit if the appraisal doesn’t meet expectations, ensuring they’re not financially penalized for a low appraisal.
Safeguards the Lender’s Investment
Appraisals are not only essential for buyers but also for lenders. Lenders rely on appraisals to ensure the home’s value is sufficient to secure the loan. If a home appraises for less than the sale price, the lender may reduce the loan amount or refuse to approve it altogether. This can leave the buyer in a tough spot, forced to make up the difference in cash or walk away. The appraisal contingency offers the buyer the option to reconsider their decision without facing financial penalties, safeguarding both the buyer and the lender’s investment.
Provides Negotiation Leverage
If the appraisal comes in lower than expected, the appraisal contingency allows the buyer to renegotiate the sale price with the seller. This provides a significant advantage, as the buyer can use the low appraisal as leverage to request a price reduction or other concessions. By giving the buyer a way to adjust the terms of the deal, the appraisal contingency offers valuable flexibility in the face of an unfavorable appraisal. This can help prevent financial strain and ensure the buyer isn’t forced to pay more than the property is worth.
When Should You Include an Appraisal Contingency in Your Offer?
Including an appraisal contingency in your offer is essential for protecting your financial interests during a real estate transaction. While this protection is beneficial in many situations, there are specific circumstances when it becomes especially important.
If you are financing your home purchase, including an appraisal contingency is crucial. Lenders require an appraisal to assess the property’s value and ensure they aren’t lending more than the home is worth. Without this contingency, you could be forced to cover the difference between the appraised value and the sale price out of your pocket if the appraisal comes in lower than expected. This could place a significant financial burden on you, especially if you don’t have additional funds to make the difference.
An appraisal contingency is also particularly valuable in a buyer’s market, where more homes are sold than buyers. In such a market, sellers are often more open to negotiations. If the appraisal comes in lower than the sale price, you can use the contingency as leverage to either renegotiate the price or walk away from the deal. This gives you the flexibility to ensure you’re not paying more than the property’s value, even if the seller is initially hesitant to lower the price.
If you’re uncertain about the fair market value of the home you’re interested in, an appraisal contingency becomes even more critical. Suppose the home’s condition, location, or comparable market sales raise doubts. In that case, this contingency allows you to back out of the deal if the appraisal comes in lower than expected, ensuring you don’t overpay for a property.
This protection is also wise if the home has unique features or potential issues. Older homes or properties needing significant repairs may not appraise at the purchase price due to factors that could affect their overall value. In these situations, having an appraisal contingency can protect you from committing to a deal that may be financially unwise if the property is valued lower than the agreed price.
While competitive markets often pressure buyers to waive contingencies to make their offers stand out, weighing the risks carefully is essential. If you’re concerned about overpaying, even in a seller’s market, consider keeping the appraisal contingency in your offer. However, this is only advisable if you’re confident in the home’s value or prepared to cover any potential gap between the appraised value and the sale price without risking financial strain.
Finally, an appraisal contingency is even more crucial if you make a smaller down payment. With down payments in the 3% to 5% range, your loan-to-value ratio is more susceptible to home value fluctuations. In these cases, the appraisal contingency provides an essential layer of security, ensuring you’re not left with a significant financial gap between the appraised value and the purchase price you must cover out of pocket.
What Happens If the Appraisal Comes In Low?
If the appraisal on the home you’re looking to purchase comes in lower than the agreed sale price, it can be a stressful situation. However, having an appraisal contingency in place can provide you with several options for navigating this challenge.
One of the primary advantages of having an appraisal contingency is the ability to back out of the deal without losing your earnest money deposit. If the appraisal comes in lower than the sale price, the contingency allows you to cancel the agreement without forfeiting the deposit. This is especially helpful in situations where the appraisal doesn’t reflect the true market value of the home or is too low to secure the necessary financing.
Alternatively, you may be able to renegotiate the sale price with the seller. A low appraisal can serve as a valid reason to request a reduction in the price, and depending on the market conditions, the seller may be open to this adjustment. In a buyer’s market or a situation where the seller is motivated, they may be willing to lower the price to align with the appraised value, ensuring that the sale price matches what the lender is willing to finance.
If the seller is unwilling to reduce the price, another option is to increase your down payment to cover the difference between the appraised value and the sale price. For example, if the home appraises for $250,000, but you agreed to pay $275,000, your lender will only finance up to $250,000. You would then need to cover the remaining $25,000 yourself. This option can be viable if you have the cash available and are committed to moving forward with the purchase.
In some cases, you might choose to request a second appraisal if you believe the initial one was inaccurate. This can be a valid option if you think the appraiser missed important details, such as recent renovations, upgrades, or comparable properties. However, it’s important to keep in mind that second appraisals can be costly, and there’s no guarantee that they will result in a higher appraisal value. You should carefully weigh this option before deciding to pursue it.
If you don’t have an appraisal contingency in your offer, your options are significantly more limited. In this case, you are legally obligated to proceed with the purchase based on the original contract terms. If the appraisal comes in low, and you don’t have the funds to cover the difference, you could be forced to forfeit your earnest money deposit. Additionally, if you back out of the deal without meeting your obligations, the seller could potentially sue for breach of contract.
Waiving the Appraisal Contingency: Pros and Cons
In a competitive real estate market, many buyers may be tempted to waive the appraisal contingency to make their offer more appealing to sellers. While waiving the appraisal contingency can have certain advantages, it also carries significant risks that could have financial consequences. Here’s an in-depth look at the pros and cons of waiving the appraisal contingency in your home purchase offer:
Pros of Waiving the Appraisal Contingency
1. Makes Your Offer More Attractive to Sellers
In a hot housing market, where multiple buyers may be vying for the same property, waiving the appraisal contingency can make your offer stand out. Sellers often prefer offers with fewer conditions, as they feel more confident that the deal will close without delays or complications. By waiving this contingency, you show the seller that you are a serious buyer who is willing to proceed with the purchase regardless of the appraisal outcome.
2. Potential for a Faster Closing Process
Waiving the appraisal contingency can expedite the home buying process. Since there is no need for an independent appraisal to confirm the home’s value, the lender may process the loan more quickly. This can be particularly beneficial if the seller is looking for a fast closing or if the seller has already received multiple offers.
3. Helps in Competitive Bidding Situations
If you are competing with multiple buyers for a property, waiving the appraisal contingency might give you an edge. In a bidding war, buyers who waive contingencies, including the appraisal contingency, may be more likely to have their offer accepted because they reduce the chance of the deal falling through due to appraisal issues.
4. Useful for Cash Buyers
If you’re paying cash for the home and don’t need a mortgage, waiving the appraisal contingency is often a straightforward decision. Since you aren’t relying on a lender to approve the loan based on the home’s appraised value, you can eliminate the appraisal contingency without worrying about financing issues. This can simplify the process and make your offer more attractive.
Cons of Waiving the Appraisal Contingency
1. Risk of Overpaying for the Home
One of the biggest drawbacks of waiving the appraisal contingency is the risk of overpaying for the home. If the home appraises for less than the agreed-upon sale price, you’ll still be obligated to pay the full amount, unless you can negotiate a lower price with the seller. This means that if you’re paying more than the home’s market value, you could be starting your homeownership journey with negative equity (owing more than the home is worth). Overpaying could also limit your ability to refinance or get a home equity loan in the future.
2. Loss of Earnest Money
In cases where the appraisal comes in low and you don’t have an appraisal contingency to fall back on, you risk losing your earnest money deposit if you decide to back out of the deal. Earnest money typically ranges from 1% to 3% of the home’s purchase price, and if you waive the appraisal contingency and the appraisal is lower than the offer, you could lose this deposit if you choose not to proceed with the sale.
3. No Room for Negotiation
Without the protection of an appraisal contingency, you won’t have the leverage to negotiate a price reduction if the home appraises lower than the agreed-upon purchase price. This could leave you in a position where you either have to come up with additional funds to make up the difference or proceed with the purchase at a price higher than the home’s actual value.
4. Potential Legal Consequences
If you waive the appraisal contingency and the sale price exceeds the appraised value, you could be legally bound to follow through with the purchase, even if you can’t secure financing for the full amount. If you choose to walk away from the deal at this point, you could be sued by the seller for breach of contract, leading to potential legal costs and further complications.
5. Limited Financing Options
If the home appraises for less than expected and you’ve waived the appraisal contingency, your lender may not be willing to approve the loan for the full purchase price. This could lead to a situation where you’re required to increase your down payment or find additional funding to complete the purchase. If you don’t have the funds available to cover the gap, you may be forced to walk away from the deal, potentially losing your earnest money and facing legal consequences.
When Should You Consider Waiving the Appraisal Contingency?
Waiving the appraisal contingency can be a strategic move in certain situations. Here are some scenarios where it might make sense:
- You’re buying in a highly competitive market where multiple offers are expected, and waiving the contingency could make your offer more attractive.
- You have enough cash or equity to cover any difference between the appraised value and the purchase price, especially if the appraisal comes in lower than expected.
- You’re confident in the home’s value and don’t believe the appraisal will come in lower than the sale price.
- You qualify for an appraisal waiver from your lender or have a strong financial position that makes it less risky to waive the contingency.
Conclusion
In the competitive world of real estate, an appraisal contingency is a powerful tool that protects buyers from overpaying for a home. It ensures that an independent appraisal supports the agreed-upon sale price and allows the buyer to walk away from the deal if the home’s value doesn’t meet expectations. While waiving this contingency can make your offer stand out in a hot market, it comes with significant risks, including the possibility of paying more than the home is worth or losing your earnest money deposit.
However, there are alternatives to waiving the appraisal contingency that allow you to strengthen your offer while still maintaining protection. By offering a larger earnest money deposit, agreeing to cover the appraisal gap, or negotiating other aspects of the sale, you can make your offer more attractive to sellers without eliminating the safeguards the appraisal contingency provides.
Ultimately, whether you choose to include an appraisal contingency, waive it, or explore other strategies depends on your financial situation, market state, and level of comfort with risk. Make sure to weigh the pros and cons carefully and work closely with your real estate agent to craft the best offer for your circumstances.