Question: I am at the beginning stages of the home buying process and my Realtor has expressed the possibility of needing to waive the appraisal contingency in order to win a bidding war. Do you mind explaining to me the pros and cons of the appraisal contingency and why it would be recommended for me to remove it from my offer?
Sure, I would be delighted to. With today being a seller’s market, it’s quite understandable that your realtor would suggest the removal of the appraisal contingency. However, it is risky. Let me tell you why.
First, let me explain what an appraisal is. An appraisal is a third party’s unbiased evaluation of the current market value of the subject property. An appraisal is done by an appraiser hired by the lender. The appraisal is used to determine how much the borrower can obtain for a mortgage on the subject property, assuming the purchaser is obtaining a mortgage on the property. Depending on the loan program, the lender will typically lend up to 100 percent of the appraised value.
An appraisal contingency protects the buyer’s interests in the event that the appraised value of the home comes in below the contract sales price. If the appraisal contingency was waived and the appraised value was less than the contract sales price, the buyer would have to pay the difference between the appraised value and the contract sales price via cash. If that is not an option and/or the buyer chooses not to proceed with the transaction, the buyer’s earnest money deposit could be at risk. In the event that the contingency is in tact, four things could happen if the appraised value comes in low:
- The seller could drop the sales price to the appraised value.
- The buyer could pay the difference between the appraised value and the contract sales price with cash.
- The seller and buyer could negotiate and agree on something in the middle.
- If nothing were agreed upon, the contract would be considered null and void.
If the appraisal came in at or above the contract sales price, no further action is needed and the transaction would proceed as usual.
So to answer your question, the pros of having an appraisal contingency from the buyers prospective are:
- Protection of the earnest money deposit in the event of a low appraisal.
- Avoiding coming up with the cash to pay for the difference between the appraised value and the contract sales price.
The cons of the appraisal contingency, in itself, are strictly on the seller. The seller’s risks would be for them having to lower the sales price to save the transaction or the deal falling apart in the event of a low appraisal.
Now, let me show you an example of how a low appraisal can make once a great purchase turn into an ugly one quickly. Lets use the example that you are purchasing a single-family home for $800,000, you plan on putting 20% down, and you have a $35,000 earnest money deposit in escrow. When making the offer on the property, you are planning on bringing $160,000 (for your 20% down-payment) plus your closing costs to settlement.
Let’s say the appraisal came in at $750,000 and you don’t have an appraisal contingency or any other means of contractual protection. You will now need to bring the 20% down of the $750,000 or $150,000 plus the difference of the appraised valued and the contract sales price or $50,000 plus your closing costs. So your thought of bringing $160,000 plus closing costs, now just turned into $200,000 plus closing costs or you could lose your $35,000 deposit.
(On a side note, with a low appraisal, make sure you revisit with your lender because when you reduce your loan amount you may be able to change your loan terms/program which could save you on your monthly payment, down payment, and interest rate on the loan.)
There are many different opinions on the appraisal concept and whether they truly due give an accurate portrayal of the market value of the property. Unfortunately, there are many factors in today’s Bethesda market that I find difficult for the appraisal to judge based on just comparable homes that have recently sold. However, the appraisers are trying to abide by the rules and regulations set for them and until those regulations adjust for times like today, the real estate market, buyers, sellers, lenders, brokers, etc., will have to deal with it.
With all of that being said, in today’s Bethesda market, sellers typically do not want to see an appraisal contingency because of the above-mentioned risks. If there is a lot of activity on a property (multiple offers), removing the appraisal contingency would be something to consider, however risky, if you did not want to lose the property.
Realtors recommend the removal of the contingency if they are confident that the home will appraise for the contract sales price or if the buyer doesn’t mind paying for the difference in the event of a low appraisal, if there is one. I never like recommending waiving the appraisal contingency because of the associated risks. However, the decision is up to the purchaser. Just make sure you understand all of the potential risks and consequences before you waive any contingency. Cash is KING! Per my last column, the perfect offer is a cash offer for multiple reasons, for the sake of this column; it is not necessary to have an appraisal done with a cash offer because there is no loan being obtained.
When submitting an offer, make sure to speak with your Realtor because even if you waive your appraisal contingency, some other contingencies and loan program disclosures in the contract have the appraisal contingency built in. So in the event of the low appraisal, you are still protected through one of the other terms of the contract even if the appraisal contingency is waived. As always, please be sure to speak with your Realtor and lender as they know your specific situation and will be able to guide you based on your financials, your goals, and the subject property’s situation.