You got your dream house after outbidding everyone who pitched an offer to the seller (congrats, by the way!). The house needs a bit of work, but you're pretty handy, and you feel like you and your partner can make it work. It passes its inspection with flying colors, but then you get to the appraisal.
You know it's bad news when you get the appraisal report, and the tiny number at the bottom shows the house appraises for $20,000 less than your offer price. You've already agreed to put down a 20% down payment, but the remaining budget was supposed to go toward your remodeling budget.
All you can think as you look at that number is, "Well, it's a good thing we got that appraisal contingency."
What is a contingency?
When working with your real estate agent, you'll probably hear the word contingency thrown around quite a bit. That's because contingencies are clauses that your agent places in your contract with the seller to allow you to back out of the deal with your earnest money intact.
Without contingencies, you can risk not only losing your earnest money but also being taken to court for more money if you back out of a house sale contract.
The three contingencies that you can expect to see on most real estate contracts are:
Financial contingencies protect you if your funding doesn't come through. While a pre-approval letter helps you get a gauge on what loan amount you are approved for, the lender doesn't officially approve you for any amount until you go to buy a home.
If the house fails the inspection, the buyer has the right to back out if they've included an inspection contingency. Typically when a house fails the inspection, the buyer and seller will renegotiate the terms of the contract so the seller either makes the repairs or drops the price. If neither party is satisfied with the terms presented, though, the seller can back out of the deal.
An appraisal contingency kicks in if the house appraises for less than the price the buyer and seller agree upon. We'll discuss this contingency more in-depth throughout this article.
Appraisal Contingency: What Is It?
An appraisal contingency allows the buyer a way to renegotiate or back out of a deal if the appraisal of the property comes back lower than the sale price.
To understand why this is valuable, you need to understand a bit about the loan process and how appraisals work.
How do appraisals work?
Many buyers get pre-qualified for a home loan before they search for a house. This gives them an idea of how much they'll be able to borrow which means they'll (hopefully) be able to find a house within their budget.
Once they find the property, buyers usually put some of their own money down on it. Most lenders give lower mortgage rates to those who put a 20% down payment on the house.
If a buyer is using a VA loan or FHA loan, they'll typically have the option of putting down a lower down payment at the price of a higher interest rate and private mortgage insurance (PMI). Both the interest rate and PMI will raise your monthly mortgage payments and interest payment.
But let's go back to the appraisals.
Once you find your house, your lender will have a third-party appraiser go out and complete an appraisal on it. The appraisal often comes back at the sale price or above. If it does, you'll be good to go! But, it could be lower. If so, the lender will lower their amount to match.
Let's say, for example, you decide to put 20% down on your house that is worth $240,000. The lender would put up the remaining 80% (or $192,000). If the house appraised for a lower value, say $229,000, the bank would only approve 80% of the appraised value, or $183,200 for you to put toward your house.
That means you would have to come up with $11,000 on top of your 20% down payment and closing costs. Ouch!
What do I do if the house appraises for less than the accepted offer price?
That's where the appraisal contingency comes in. You really have three solid options when your house appraises for less than the accepted offer price:
- Pay the difference
- Renegotiate the offer price
- Back out of the offer
Pay the Difference
If you have cash on hand and you really want the house, you could pay the difference. The difference between the loan amount and asking price could be a few hundred dollars to tens of thousands of dollars. If it's a bit much for you to take on and you have another property already, you could take out a home equity line of credit known as a piggyback loan. A piggyback loan is a second mortgage on a house that typically has lower interest rates than taking out a regular loan at the bank.
Renegotiate the Offer Price
The seller is usually just as surprised as the buyer (if not more) that their house didn't appraise. When it comes down to it, sellers usually do one of two things when their house appraises for less: vehemently stick to their asking price or renegotiate.
If you are able to renegotiate, the house is probably yours and the sale can move forward. If you can't renegotiate, however, it's time to use the appraisal contingency.
Back Out of the Offer
If you've tried renegotiating and attempted to pay the difference and it's just not happening—it's time to back out of the deal. This is where your appraisal contingency protects you.
Your appraisal contingency allows you to back out of the deal without penalty if the house is not appraising for the asking price and you are unable to renegotiate.
Backing out using the appraisal contingency also gives you back your earnest money, which is a percent of the home sale price that you put down to secure your spot in the sale.
Should I waive my appraisal contingency?
Some people waive the appraisal contingency to make their offer sweeter to the seller. Some sellers encourage this by getting an appraisal beforehand and making that information known to the buyer. This sounds good in theory, but should you waive your appraisal contingency?
If you are borrowing money from a lender, they will most likely conduct their own appraisal even if the seller has already gotten one. If the appraisal comes back lower than the initial appraisal, the lender will go with their appraisal and refuse to lend the full amount. At that point, if you waive your appraisal contingency, you will either have to renegotiate, pay the difference, or back out and lose your earnest money.
If you are buying the house in cash, waiving the appraisal contingency might not be a bad idea. Before you waive it, however, your own research based on the comps in your area is key to ensuring you are paying a good price for the property.
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