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After a buyer puts in an offer or purchase contract and makes a good faith deposit (aka earnest money deposit), there are only a few boxes left to check before the sale goes through. But what happens when the home appraisal comes back low, essentially warning you that you’re about to overpay for the home you want.
This is when it’s useful to have an appraisal contingency in place.
An appraisal contingency lets a home buyer back out of a home purchase and gets them their earnest money deposit back. It protects buyers when a house is appraised for less than their offer. With an appraisal contingency clause added to your offer, you can feel confident that you won’t lose your deposit in case the appraisal comes in low.
A contingency is a clause written into a purchase contract that makes a sale “contingent” on meeting a condition(s). If the contingency is not met, the buyer (or seller, in some cases) can back out of the contract without fear of financial or legal repercussions.
Without a contingency, backing out of a real estate contract is considered a breach of contract. A buyer could lose their good faith deposit or end up paying other monetary damages.
You’ll find a handful of common contingencies in purchase contracts. Here are a few you may come across:
- Financing contingency: The sale is contingent on the buyer securing financing. The buyer can back out if their lender doesn’t approve their mortgage.
- Inspection contingency: The sale is contingent on the results of the home inspection. Depending on what the inspector finds, the buyer can either negotiate repairs or back out of the sale.
- Home sale contingency: The sale is contingent on the buyer selling their current home by a specified date. If they can’t sell their home during that time frame, they may not have the money to buy a new house, so they can back out of the contract.
How Appraisal Contingencies Protect You
Appraisal contingencies are designed to protect buyers from overpaying and protect lenders from overlending for a property.
If you’re putting in a purchase offer, an appraisal contingency is practically a must.
If you get a mortgage loan without an appraisal contingency, you might be at risk of either paying the difference between the appraised value and your offer (aka the appraisal gap) or being in breach of contract if you can’t pay the difference. Either way, you’re liable as the buyer.
How an Appraisal Contingency Works
Let’s walk through how an appraisal contingency works.
- An appraisal contingency clause comes up during the purchase offer stage. The buyer lists their contingencies in their offer letter.
- If the purchase offer is accepted, the contingencies become part of the purchase agreement, and the buyer makes a good faith deposit.
- The lender chooses a professional appraiser, and the buyer pays them to appraise the property. To determine the market value of the home, the appraiser will use comparable area home sales, the property’s condition and other factors.
- The appraiser will provide a copy of the appraisal report to the buyer and their lender. The lender needs to make sure they aren’t going to lend more money than the property is worth.
If the appraised value of the property is close to or higher than the purchase price, you’re all set. The sale can go through. If the appraised value is lower, the appraisal contingency gives you the freedom to back out of the sale.
Now, even though you can walk away, you shouldn’t exercise that option until you talk to the seller and explore all your options.
Let’s look at an example of an appraisal contingency so you can see it in action.
Appraisal contingency example
Close your eyes and imagine your dream house. #Manifesting
You offer $250,000 for the house and include an appraisal contingency in your offer letter. Your lender is willing to lend you $200,000 (that’s 80% of the purchase price). The remaining $50,000 is sitting in your savings account, ready to make a 20% down payment.
Your lender arranges the home appraisal – and you wait. You get the report, and you see the appraiser has assigned the home a fair market value of $190,000. Quick math: That’s $60,000 less than the purchase price and $10,000 less than the mortgage.
Because your lender won’t lend you more than the appraised value, you’re on the hook for that $10,000 difference.
There are many ways to handle this situation, but remember that your appraisal contingency gives you the freedom to back out of the sale penalty-free and get your good faith deposit back.
What Happens When the Appraisal Is Less Than Your Offer
If the home’s appraisal value is lower than the purchase price, there’s no need to panic. You have a few options you can explore. Communicate with the seller and decide which option works best for both of you.
Make a larger down payment
Because your lender won’t cover the appraisal gap, your first option would be to make a larger down payment.
Yes, you could walk away from the deal because you added an appraisal contingency to your purchase offer. But this is your dream home we’re talking about, right? If you think it’s worth the extra money and covering the shortfall won’t destroy your home buying budget, consider paying the difference.
Negotiate with the seller
If the seller is highly motivated to sell, they may be open to compromise. Ask them if they’d consider lowering the sale price to the appraised value or covering a portion of the appraisal gap to keep the sale moving forward.
Get a second appraisal
Depending on the type of loan you have, your lender may allow you to dispute the appraised value and get a second appraisal.
Pro tip: Only try this if you and the seller are certain the appraised value is wrong, and you’ve got data to support your claim.
If this tactic sounds appealing, we’ve got another pro tip for you: Talk to your real estate agent before you do anything. Use their market insight to help you make a final decision.
Keep in mind that this choice comes with a cost. As the buyer, you pay for the appraisal. But to encourage you to challenge the appraisal, the seller may offer to split or fully cover the cost.
Back out of the purchase contract
You and the seller have spent time, energy and money on the home. No one wants to see the deal fall through, but sometimes the best choice is to take advantage of the exit an appraisal contingency offers. If the appraised value of the home is lower than the sale price, you can back out of the sale without any fear of consequences.
If you explored all your options and none of them worked for you, backing out might be the right decision.
Should You Waive the Contingency?
Appraisal contingencies are very common and rarely waived. Including one in your offer shouldn’t hurt your chances of purchasing a home, but there are a few things to consider.
Waiving the appraisal contingency may be advantageous in some cases. To figure out if waiving the contingency would benefit you, you’d need to do your homework and talk with your real estate agent first.
There are two instances when waiving an appraisal contingency would make sense.
In a seller’s market
If you’re in a seller’s market (and who isn’t these days), demand is high, and buyers are willing to pay more for the limited supply of homes on the market.
In this scenario, waiving your appraisal clause would make you a more attractive buyer because you’re bound to your offer price no matter what the appraised value is. Plus, in a seller’s market, a low appraisal is unlikely.
If you find yourself in this position, you should only waive the contingency if you can afford to make a larger down payment than you planned.
For a cash offer
Waiving the appraisal contingency also makes sense if you’re making a cash offer. With a cash offer, you know you can afford the sale price.
Enjoy Peace of Mind
An appraisal contingency offers peace of mind. You know you can back out of a sale if a home’s appraised value is lower than your offer price. The contingency protects you and your earnest money deposit.
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The Short Version
- An appraisal contingency lets home buyers back out of a purchase with their earnest money deposit, protecting buyers when the home appraisal is lower than their offer
- If you’re putting in a purchase offer, an appraisal contingency is practically a must. Lenders won’t give you a mortgage for more than a property’s appraised value
- Appraisal contingencies are very common and rarely waived. Including one in your offer shouldn’t hurt your chances of purchasing a home, but there are a few things to consider