Appraisal contingency facts to know
You’ve found the home of your dreams, and so far, things are going smoothly. The seller’s accepted your offer and your mortgage lender has pre-approved your loan. What could possibly go wrong?
In a word, the appraisal.
A home appraisal may reveal that the property doesn’t present sufficient collateral to support the lender’s loan amount. How do you navigate such a tricky situation?
Your lender's financing contingency will likely cover you in those scenarios, but there's another option to consider: adding an appraisal contingency clause.
Appraisal contingencies protect the buyer when the value of the home doesn’t line up with the sale price. Building an appraisal contingency clause into your purchase offer ensures your future mortgage payments accurately reflect your home’s true value. In the worst-case scenario, it even gives you the flexibility to walk away from a bad deal.
Here are some key facts you should know about your appraisal contingency options.
What is an appraisal contingency?
An appraisal contingency clause is a condition built into a real estate contract that gives the buyer the right to walk away from the transaction if the appraised value of the property is lower than the agreed-upon purchase price. These clauses are much more common in transactions involving Federal Housing Administration (FHA) loans, since buyers in those situations have less flexibility to increase their down payment to adjust the loan-to-value (LTV) ratio in response to appraisal reports. You’re far less likely to run across an appraisal contingency when using conventional financing.
Such contingencies frequently pop up when buying or selling a home. In fact, every real estate contract includes contingencies of one kind or another. You’re probably familiar with a few of them already. For example, any sale involving financing is contingent on the buyer securing a mortgage loan to cover the remainder of the purchase price after the down payment.
When you make an offer on a home, you have the option to include contingencies of your own too. For instance, your offer may be contingent on you selling your current home and putting the proceeds from that sale toward your new purchase.
Appraisal contingencies add another condition that must be met before the sale can be completed — in this case, protecting you as the buyer from spending more than you should on a new piece of property. Keep in mind that they can also make your offer less attractive if a seller is considering multiple bids from buyers who aren’t attaching similar conditions to their offer.
How do appraisal contingencies work?
A home appraisal is a routine step in the homebuying process, occurring just before closing. An appraisal contingency clause notifies the seller that your purchase offer is only good if the appraiser’s home value matches or exceeds the amount you have agreed to pay. If the appraiser comes back with a home value well below the asking price, you can walk away from the deal with your earnest money deposit in hand.
Let’s say you’ve put in an offer of $300,000 on a house. After assessing the property, comparable home sales in the area and the local housing market, the appraiser tells you the house is really only worth $250,000. You can then exercise your appraisal contingency clause to back out of the sale, even if you’ve already agreed in principle to buy the property. You’ll be out the cost of the appraisal itself, of course, but that’s only a couple hundred dollars compared with the thousands of dollars you might otherwise lose in earnest money. If you’re not sure the best way to proceed, your selling agent will compare similar listings to determine what a fair offer would be for the property and advise you accordingly.
Appraisal contingencies also give you the power to negotiate a better sale price and ensure you’re making a sound real estate investment with any transaction. Ask your real estate agent to put those conditions, along with any other contingencies you may want, into your purchase offer.
How appraisal contingencies save you money
Simply put, appraisal contingencies prevent you from paying more than you should if the home is under-appraised. As we noted earlier, appraisal contingencies also allow you to back away from an unfavorable deal while both keeping your earnest money deposit and avoiding paying any additional penalties.
Otherwise, you might lose your deposit if you don’t have a contingency clause built into your real estate contract. Earnest money usually covers 1-2% of the total purchase price, but can creep up to 5% or even 10% of the asking price in highly competitive real estate markets. In either case, that’s a pretty big chunk of change to hold onto if the sale falls through.
Secure your loan approval with an appraisal contingency
There’s another important point to think about that isn’t directly tied to saving you money: Your lender is unlikely to loan you more than the appraised value of the home. Keep in mind that appraisals protect lenders as well as buyers. Banks and mortgage lenders want to be sure that they will be able to recoup their money on any loan they offer.
With that in mind, it’s not unusual for a lender to rescind a loan approval if the appraiser comes back with a dollar figure significantly below the purchase offer — and that could leave you in a pretty tough spot as a prospective buyer.
Is there an appraisal contingency deadline?
Although there’s no hard-and-fast rule about appraisal contingency deadlines, no seller is just going to sit around and wait for a prospective buyer to make up their mind — especially if they have other offers on the table. Following industry standards, the seller will likely expect the buyer to close on the house within two weeks of the appraisal. Dragging your feet and causing delays at this critical juncture could create friction with the seller and make negotiations on the final sale price, requested repairs or property improvements more combative than they need to be.
Keep in mind that it may take up to a few weeks for an appraiser to set up the inspection, complete the review process and produce their report.
Know these other types of contingencies
An appraisal contingency is just one of several safeguards built into purchase contracts to protect the different parties involved in real estate transactions. Some other major types of contingencies to know include:
- Inspection contingency
- Financing contingency
- Title contingency
- Home sale contingency
A home inspection is another routine step when buying a house, and it may uncover similar issues relevant to an appraisal. Plumbing, electrical and structural problems can turn up during home inspections, giving buyers the opportunity to negotiate the purchase price or request that the seller make repairs as a condition of the sale.
Any real estate transaction that isn’t paid in full will require financing, and those purchases are always dependent on the buyer securing a home loan before moving forward. Financing contingencies typically give the buyer a certain amount of time to find a lender that will extend them a mortgage loan. If they’re unable to do so within that time frame, the deal could be dead in the water.
It’s not always clear who has ownership rights over a piece of property. Liens, encroachments and easements can make the seemingly simple task of determining ownership a messy affair. In those situations, homebuyers may find themselves caught up in a protracted legal process to address ownership disputes before the title clears.
Any standard sales contract will stipulate that the seller is able to pass a clear and merchantable title to the new owner. Furthermore, no lender will close on a loan without verifying that the title is clear of defects. In any case, title contingencies give you additional flexibility to walk away rather than deal with those headaches.
Home sale contingency
As noted earlier, a purchase offer may be contingent on the buyer selling their current home by a certain date. A home sale contingency gives you more purchasing power when buying a house since you can devote those proceeds toward your new home. It also protects you from the financial burden of carrying two mortgages at once if you’re unable to sell your property within the stated time frame. As with an appraisal contingency, you run the risk of sending the seller a less appealing offer when you add these conditions to your bid, especially in competitive real estate markets.
When should you waive the appraisal contingency?
In most cases, there’s really no clear benefit for the homebuyer to waive an appraisal contingency. It’s there to protect your best interests, after all.
That being said, there are some scenarios where you might consider removing the appraisal contingency clause from your purchase offer:
- You want to make your offer more enticing to the seller
- You plan to make a significant down payment
- You’re paying in full
- You don’t care too much about the appraised value of the property
You want to make your offer more enticing to the seller
Appraisals can be headaches for buyers and sellers alike. A seller may not want to run the risk of an appraisal coming back with a lower home value than their asking price. In a hot real estate market with multiple offers on the table, a prospective buyer who’s willing to waive the appraisal contingency clause may have a more attractive offer than someone who won’t take that same risk.
You plan to make a significant down payment
Aside from cost savings, one of the biggest reasons to add an appraisal contingency clause is to avoid a situation where your mortgage lender rescinds their loan approval. If you were planning to put down a hefty down payment above the standard 20% anyway, you would potentially offset any valuation gaps and put the lender's mind at ease. As such, a low appraisal might not impact your financing situation at all.
You’re paying in full
If you’re paying in full (and in cash) for your property, then you don’t need to worry about securing a loan at all. Of course, you still run the risk of overpaying without an appraisal contingency clause, but at least there’s no chance of your financing falling through during the final stretch.
You don’t care too much about the current value of the property
Depending on the circumstances, the market value of the home may not sway your purchase decision one way or the other. Let’s say you plan to tear down the existing structure and redevelop the land. You’re taking a long view of your investment in that scenario, and your vision doesn’t necessarily involve the property as it exists today. As such, deviations in home value probably aren’t going to move the needle much, if at all, for you.
Truthfully, the situations described above are unlikely to apply to the vast majority of homebuyers, with the possible exception of making your purchase offer stand out from other prospective buyers. Even so, the risk you run waiving appraisal contingency probably isn’t worth the edge you gain in the housing market.
Appraisal contingency clauses protect homebuyers and mortgage lenders from paying more than they should for any property. They also give you as the buyer the upper hand when negotiating a lower sale price on a home that’s been appraised below market value.
On the other hand, appraisal contingencies may weaken your offer in the face of more competitive bids with fewer strings attached.
In general, these types of contingencies are most useful when an FHA loan is involved. Homebuyers who rely on conventional mortgages, meanwhile, will likely find that their financing contingency adequately protects their interests. If the value calculated through the appraisal doesn’t support the loan terms requested, your lender isn’t going to approve the mortgage. When that happens, you’re free to move on from the transaction.
Given these considerations, it’s always a good idea to consult your real estate agent before deciding to add an appraisal contingency clause in your purchase contract.