Appraisal Contingency: What It Is and Why You Need One
What if, after years of saving up money to buy a house, you suddenly learn that you need to come up with another $50k — or you risk losing your earnest money deposit and your dream home? This is a harsh reality for some homebuyers and exactly why you need an appraisal contingency.
An appraisal contingency offers you a legal escape route in the event that the appraised value of a house deviates from your agreed-upon sales price. This contingency also gives buyers negotiating power if there’s an appraisal gap because they can opt to walk away from the deal and retain their earnest money deposit — which a seller might be hesitant to let happen.
In this post, we’ll discuss how appraisal contingencies work, what they mean for buyers and sellers, and how they impact real estate transactions.
Let’s get started!
What Are Contingent Offers?
Contingencies are conditions that must be met before a real estate transaction can be completed. When making your purchase offer, home sale contingencies provide you with a way out of the contract and give you the option to get your earnest money back, should a problem with the home’s condition or financing arise.
Contingencies protect prospective homeowners from all sorts of situations. There are three main types of contingencies you can include in your offer:
- Mortgage contingencies, also known as financing contingencies, protect you if your mortgage loan amount doesn’t get approved within a specific time frame.
- Inspection contingencies require a house to complete a home inspection prior to the purchase.
- Appraisal contingencies require that the house appraises for what you’ve agreed to pay for it (or more) in your purchase contract.
We’ll discuss mortgage and inspection contingencies in more detail in a later post. Today, we’re taking a deep dive into appraisal contingencies.
Why Are Appraisal Contingencies Important?
When you make an offer on a house, you’re telling the seller that you will agree to pay $x amount for a home. Your offer may be the asking price, the fair market value of the home, or more or less, depending on the housing market. If it’s a buyer’s market, you may offer a little less because there are more homes than buyers available. It may be more if it’s a seller’s market and/or if you get into a bidding war.
To show the seller you’re serious, you also make an earnest money deposit — usually 2-3% of the home purchase price.
You can offer whatever you want if you’re buying the home in full with cash. However, if you need to take out a loan, your mortgage lender needs to know the appraised value of the home. So they will hire a licensed appraiser to inspect the home, research comparable sales or “comps,” and then put together an appraisal report.
The key takeaway is that your purchase offer and the appraised value of a home are not the same. If the appraised value is less than your purchase offer, also known as a low appraisal, your lender may not loan you the full amount you need.
If you don’t have an appraisal contingency, you’ll either have to pay the difference, negotiate with the seller, or risk losing your earnest money deposit. But if you’ve included an appraisal contingency in your offer, then you have some options.
What Are the Buyer’s Options Without an Appraisal Contingency?
Let’s say Amy signs a purchase agreement with a seller to buy their home for $1,000,000 and puts down 2%, or $20k, in earnest money. However, she doesn’t include an appraisal contingency clause in her offer contract. If the home appraisal then comes in at $950,000, Amy has these choices:
- Pay the $50k difference.
- Hope the seller is open to negotiating.
- Request a second appraisal.
- Walk away and lose her $20k earnest money deposit.
Simply put, Amy’s options are not ideal because she didn’t include an appraisal contingency. Paying the difference ensures she can buy the home, but $50k is a lot of additional money to come up with — especially considering that it’s on top of the down payment, closing costs, moving costs, painting and decorating, furniture shopping, etc.
The seller may negotiate with Amy, but they have a clear advantage in this situation unless they need to sell quickly. Depending on the market, they may be able to get a better deal with another buyer, all while keeping Amy’s earnest money.
Amy can request a second appraisal, but she must first find mistakes in the first appraiser’s report to prove that the house is worth more than its appraised value. That’s not an easy task.
If Amy walks away, she’s out $20k and has nothing to show for it but a harrowing learning experience and a depleted bank account.
What Are the Buyer’s Options With an Appraisal Contingency?
If Amy does have an appraisal contingency clause in the contract, she’s in a much better position. She might still agree to pay the $50k, but if she decides she doesn’t want to or can’t afford to, she won’t lose her $20k deposit.
Since the seller won’t get to keep her earnest money if she walks away, they will be more motivated to work with her to close the appraisal gap. They might agree to pay some or all of the $50k difference or lower the purchase price to $950,000 so that neither of them has to pay it. Amy is also better positioned to negotiate closing costs so that she’ll have more money to either close the appraisal gap or for something else house-related.
What Are the Seller’s Options With an Appraisal Contingency?
While appraisal contingencies are more likely to help buyers like Amy, sellers also have options. If there’s an appraisal gap and the buyer has an appraisal contingency, the seller can renegotiate to find a solution that benefits both sides. They can also fix any issues identified in the appraisal report, and request a second appraisal. If their home then gets appraised for more money, that can close the gap between the purchase offer and the appraised value.
In some cases, sellers can also offer seller financing, which is basically a mortgage agreement between the seller and the buyer to cover the remainder of the purchase price. This financing agreement doesn’t involve a lending institution and may come with limitations, but it’s an additional option to consider.
Appraisal Gap Coverage Clauses
Sellers can also include an appraisal gap coverage clause in their sales contract. This clause requires the buyer to buy the home for the offer price even if the appraisal comes back lower than the agreed-upon purchase price. There’s usually a fixed amount of gap coverage agreed upon by the buyer and the seller.
To go back to our example, if there’s an appraisal gap coverage clause that requires Amy to pay up to $20k more than the appraised value of the home, she’ll be required to pay at least $970,000 of the $1,000,000 home purchase price if there’s an appraisal gap. Since she risks losing her $20k earnest money deposit and is required to pay at least $970,000, if she can’t come up with the additional $20k, the seller has a substantial negotiating advantage.
How Do Appraisal Contingencies Impact the Sale of a Home?
A survey by the National Association of Realtors found that appraisal issues account for 7% of real estate sales contract delays. Some of the most common reasons for these delays include:
- Bidding wars
- Lack of available comps
- The quick rise in home prices
- Sellers going the for-sale-by-owner (FSBO) route
Even though your odds of having an appraisal issue arise are low, it’s usually advantageous to include an appraisal contingency. The only times you should ever consider waiving the contingency is if you have to in order to get your offer accepted or if the chances of a low appraisal are extremely unlikely. Even in those situations, we don’t recommend it, and you should keep extra cash on hand, just in case.
Homebuying Isn’t Contingent on Having a Real Estate Agent
The real estate process is daunting by design, but it doesn’t have to be. At Aalto, we’re here to help you make informed decisions about your next real estate transaction.
We’re a self-service real estate platform dedicated to shifting the balance of power in residential real estate away from industry insiders and toward consumers. One way we do that is by educating buyers and sellers alike about appraisal contingencies, home inspections, and the many other moving parts that make up the homebuying process.
Are you ready to take control of your next real estate transaction? Get started on Aalto today!