What is an Appraisal Contingency?
What You Should Know
- An appraisal contingency allows a buyer to cancel a home purchase.
- The purchase is canceled if the appraised value is less than the purchase price.
- The buyer won’t incur any cancelation penalties and will not lose their earnest money.
- Although not required, an appraisal contingency is negotiated with the home offer.
- In a seller’s market, an appraisal contingency will make your offer less competitive.
What Is an Appraisal Contingency?
An appraisal contingency is a clause that is included in some property purchase contracts. This clause allows a buyer to cancel the purchase if an appraised value of the property is less than the price outlined in the contract. This practice is most common when financing a house or when the housing market is volatile.
An appraisal contingency provides protection to a buyer against purchasing an asset at a predetermined price without knowing the value of the asset. A buyer can reasonably expect that they will not get a bad deal since they can back out of the deal if the value of the property is lower than the price. A creditor also benefits by ensuring that the collateral on the loan is reasonably priced, and if the buyer defaults, they will be able to recover the debt outstanding.
| Fast Answers About Appraisal Contingencies | |
|---|---|
| What is it? | It allows the buyer to walk away from a deal without penalties if the home appraisal is lower than the purchase price. |
| How does it work? | The contingency is included in the purchase agreement. If the seller accepts the offer, it will protect the buyer as the transaction finalizes. |
| When to use one? | A buyer should always try to have one. However, in sellers’ markets it will make purchase offers less competitive. |
| How to exercise one? | The contingency can be exercised by the buyer after receiving a low home appraisal. |
| What are the buyers’ options after exercising? | The buyer can either;
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How Does an Appraisal Contingency Work?
An appraisal contingency is a clause that is inserted into a purchase agreement that is sent to a seller. This way, a seller should know that the buyer is planning to have the property appraised, and the deal may not go through if the appraised value is less than the price listed in the agreement without losing their earnest money or incurring any other penalties related to cancellation of the agreement.
When it comes to an appraisal, a buyer and a lender find a professional appraisal company to estimate the value of a property in current market conditions. When an appraiser is finished with the property, the appraiser delivers a detailed appraisal report to the buyer and the lender. Based on this document, the buyer may decide whether they would like to purchase the property.
Since most lenders are not allowed to issue mortgages that are higher in value than the value of collateral, a lender may also decline to issue a mortgage if the appraised value of the property is less than the value of the loan. If a buyer still would like to purchase a house, they may need to pay a higher down payment to satisfy an appropriate loan-to-value (LTV) ratio that a lender may require. With an appropriate LTV ratio, a lender is not risking losing money in the event of default by the borrower because they could sell the collateral that is valued more than the debt outstanding on the loan.
Tip: Why Your Purchase Offer Was Rejected
An appraisal contingency will cancel a real estate transaction if the property’s appraised value is lower than the purchase price. If a home seller has many interested buyers, they will prefer simpler offers where there is less potential for the transaction to fall apart.
In competitive purchasing markets, buyers with fewer contingencies are more likely to have their offer accepted. In some cases, sellers are willing to accept a lower purchasing price for fewer contingencies because the deal is more likely to finalize.
When to Use an Appraisal Contingency?
An appraisal contingency does not have to be always present in the purchase agreement. There are multiple scenarios where an appraisal contingency may not be necessary or even hurt the chances of getting a property. An appraisal contingency may not be as important in certain situations, such as the following:
- A buyer is paying cash for a property.
- A buyer has more than 20% - 25% for a down payment.
- A buyer is planning to redevelop the property.
- A lender does not require an appraisal.
An appraisal contingency may lower the chances of getting a property if a person in financial distress is trying to short sell a property. The seller may not be willing to take extra time for property appraisal. Since they are in financial distress, they may want to sell the property as fast as possible. In this case, instead of waiting for an appraiser to finish their job, they are likely to choose to go with a person who can close the deal quickly. Additionally, if you are making a backup offer you’re more likely to be approved with fewer contingencies.
Another example when an appraisal contingency may hurt the chances of getting a property is a hot real estate market. When there are a lot of buyers and not as many sellers, the sellers tend to have multiple offers to purchase their property. Because of multiple offers, the sellers can pick the best offer. Since there is a possibility that the property will not sell with an appraisal contingency clause, the sellers may favor an agreement without this clause.
How to Exercise Appraisal Contingency?
If a buyer has inserted an appraisal contingency clause, and the appraisal value of the property is less than the price of the property listed, then a buyer, a seller, and a lender have certain options to exercise that may affect the deal.
In this situation, a lender may refuse a mortgage loan. Lenders require a certain LTV ratio for a mortgage. Most of the time, the LTV ratio is around 80% on a conventional mortgage. If the appraised value of a property, which is also collateral, is less than the price of the property, then the LTV ratio might be too high for a lender to issue a mortgage loan. In this case, the lender may refuse to issue a loan unless a borrower puts a larger down payment to decrease the LTV ratio to an acceptable level.
If an appraised value of a property is acceptable for a lender, then the buyer has to decide whether they are willing to purchase the property at a predetermined price. The buyer might likely be better off refusing the deal if the difference between the asking price and the appraised value is large.
Additionally, the buyer may try to negotiate the price with a seller based on the information provided by an appraiser. On the other hand, if an appraised value is smaller, but it is not that much different from the purchase price, then the buyer may consider purchasing the property depending on various personal and economic factors.
A seller may try to renegotiate the price of the property if a buyer chooses to exercise the appraisal contingency clause. In case when a seller has multiple offers, they may look into other offers and see whether they are interested in any of them. A seller may still receive offers on a contingent listing. If there are offers that are not contingent on the appraised value, then the seller may want to choose another offer.
On the other hand, if the property has a much higher price than an appraised value, then the seller may want to negotiate the price with the buyer because it is unlikely that the house will be sold at a much higher price than comparable properties.
Example of an Appraisal Contingency
Suppose a buyer is looking to buy a property for $500,000. A buyer is approved for a mortgage with a maximum LTV ratio of 80%. This means that the buyer has to contribute 20% as a down payment, which is equal to $100,000 for a property valued at $500,000. A buyer sends an offer on the property with an appraisal contingency clause.
An appraisal reveals that the value of a property is only $480,000, which is less than the selling price of the property. There are 3 options described below a buyer can choose from in this scenario.
| Metrics\Options | Renegotiate Price (Decrease by $20,000) | Increase Down Payment (Increase by $20,000) | Decline the Deal |
|---|---|---|---|
| Home Purchase Price | $480,000 | $500,000 | $0 |
| Value of Property Acquired | $480,000 | $480,000 | $0 |
| Mortgage Down Payment | $96,000 | $116,000 | $0 |
| Mortgage Principal | $384,000 | $384,000 | $0 |
| Loan-to-Value Ratio | 80% | 80% | 0% |
Option 1: Renegotiate the Deal
If the buyer would like to purchase the property, they may try to renegotiate the price with the seller. Since an appraised value of a property is considered an objective metric, the buyer can make a reasonable offer based on the appraised value. If the seller chooses to accept the appraised value as a selling price, then the buyer and the seller may have a deal.
In this case, the buyer has to pay $480,000 for the property. The down payment is equal to $96,000, which makes the LTV ratio equal to 80%.
Option 2: Pay a Larger Down Payment
If the seller is not willing to accept a lower price, and the buyer is willing to pay more for the house than its appraised value, then the buyer may put a larger down payment to keep the LTV ratio at 80%.
The buyer has to pay $500,000 for the property. Since the value of the collateral is only $480,000, the loan value must be $384,000 to satisfy a maximum LTV ratio of 80%. In this case, the buyer has to put a down payment of $116,000.
Option 3: Look For Another Deal
If the seller is not willing to accept the lower price, and the buyer is not willing to pay more for the house than its appraised value, then the buyer should walk away from the deal and look for another property.
Since the buyer has the right to walk away from the deal, they can just look for a more suitable option. In this case, the buyer does not take a loan and does not pay a down payment.