Appraisal Contingency: What It Is and How It Can Help

An Appraisal Contingency Protects You from Paying More than a Home Is Worth -- or Having Problems with Your Loan-to-Value Ratio

When you make an offer on a home, you want to make sure you are paying a fair price. You also need the home to appraise high enough to qualify for your home loan, since lenders can't loan you more than a certain percentage of a home’s fair market value. Appraisals set the fair market value of a home when you are getting a mortgage.

An appraisal contingency helps to protect you from both overpaying and having problems with your mortgage.

This guide explains what an appraisal contingency is, why waiving an appraisal contingency could be a problem if you're buying a home, and what an appraisal contingency clause looks like in a home purchase agreement.

What Is an Appraisal Contingency?

An appraisal contingency is a clause that's often included in an offer to buy a house. When you make an offer, you can include an appraisal clause to make closing contingent on the home appraising for at least as much as you're paying. If the appraisal is low, the home appraisal contingency allows you to negotiate the price or walk away with your earnest money deposit.

Making an offer with no appraisal contingency can be very risky for buyers. When there's an appraisal gap, or a difference between the purchase price and the home's market value, the buyer may not be able to qualify for a mortgage without bringing cash to the table. That's because mortgages have a max loan-to-value ratio (LTV) and can’t be approved for more than a certain percentage of a home's value (which varies by the type of mortgage).

Buyers include an appraisal contingency because it allows them to create a precondition that must be met for the deal to close. If the condition isn't met, the buyer has the option to walk away from the deal without penalty. Sellers can then lower the price to make up for the appraisal gap, or put the home back on the market if the condition isn't satisfied.

How Do Appraisal Contingencies Work?

When a buyer makes an offer with an appraisal gap contingency, the seller can decide whether to accept the offer with the precondition attached. If the seller accepts the offer with the precondition, then the buyer’s mortgage company can move forward with an appraisal.

The purpose of the home appraisal is to determine the fair market value of the home. Lenders are required by law to have a third-party professional appraiser determine a home’s value because the home acts as collateral for the loan. If the appraised fair market value is less than the sales price, the lender won't be able to loan the full mortgage amount to the buyer.

Most mortgages require the maximum LTV ratio to be below 97% of the fair market value, although some go as high as 100% (or even 110% for a VA Loan with fees included). If the fair market value is lower, the buyer has a few options, assuming they have a home appraisal contingency:

• Walk away from the sale and get their earnest money deposit back because the contingency wasn't met
• Negotiate with the seller to cover all or part of the appraisal gap by lowering the price to the fair market value
• Go through with the deal, but bring extra money to cover the appraisal gap

Without an appraisal contingency, coming to the table with cash or walking away and losing their deposit are their only choices. Buyers need to have an appraisal clause in their agreement to avoid losing their earnest money deposit and to give them negotiating leverage in the event of a low appraisal.

What It Means if the Appraisal Is Low

If an appraisal is low, it means that an independent third party has determined that the home is worth less than the agreed-upon purchase price. Appraisers make this determination by inspecting the home, considering market trends, and using comparable sales.

The appraisal gap means the buyer may be overpaying for the home.

While a buyer can always choose to do that, they may need more money to be able to close. If they can't come up with the extra cash to cover the appraisal gap, they may not be able to secure financing for the home, so they won't be able to move forward.

Appraisal Contingency Example

Let's look at an appraisal contingency example to better understand the answer to the question, what is an appraisal contingency. A buyer has $12,000 to put down on a home they want to buy for $400,000. This means the buyer is applying for a $388,000 mortgage. If the home appraises for $390,000, there is an appraisal gap. The lender would only be able to loan the buyer 97% of $390,000, or $378,300. This creates a $9,700 appraisal gap.

The buyer would need to get the seller to lower the price or would need to make up the difference and make a $21,700 down payment. If the seller won't drop the price, and the buyer doesn't want to (or can't) make up the difference, the buyer must walk away.

What It Means if the Appraisal Is Higher

If the appraisal is higher when there is an appraisal contingency clause, it means that the appraisal condition is satisfied. The buyer and seller can move forward with the transaction.

Benefits of Appraisal Contingency Clauses

It's important for you to be able to do more than just answer the question: What is an appraisal contingency? You should also know the benefits of including this clause in your purchase offer.

Here are some of the biggest benefits for buyers of including an appraisal gap contingency when they make an offer to purchase a home.

• Protection: An appraisal contingency offers financial protection to buyers. It ensures they don't pay more than the fair market value for a home. It also helps buyers to avoid having to bring extra money to the table to close on a home loan when there is a home appraisal gap
• Flexibility: Including an appraisal contingency gives buyers more flexibility. They can choose to walk away from a purchase offer without losing their earnest money deposit if the home does not appraise for as much as they agreed to pay for it.

A home appraisal contingency is one of the most common types of home buying contingencies, because most mortgages require home appraisals and because a buyer may not be able to cover the appraisal gap when they are paying above the home's fair market value.

Can You Waive an Appraisal Contingency?

Waiving an appraisal contingency can make an offer more attractive to a seller. That's because sellers don't have to worry about buyers walking away or re-opening negotiations if the appraisal is below the fair market value of the home.

However, submitting an offer with no appraisal clause can be very risky because it could mean that you either have to come up with extra money to qualify for a mortgage or walk away and lose your earnest money deposit if the home's value comes in low.

Some buyers opt out of an appraisal contingency but instead make an offer that specifies they are providing appraisal gap coverage. That means they agree to pay extra out of pocket, up to a certain amount, if the home appraisal comes in lower.

This approach allows a buyer to make their offer more competitive in a seller's market, without taking on the full financial risk of no appraisal contingency at all.

Appraisal Contingency FAQs

Still need to know more? Here are the answers to some frequently asked questions about appraisal contingencies in home purchase offers.

How Common Is a Home Appraisal Contingency?

Home appraisal contingencies are very common. Since lenders typically require appraisals and many buyers can't afford to pay the difference if a home appraises for far less than the offered price, buyers include these contingencies to protect themselves and walk away when an appraiser says the home is worth much less than they're paying.

How Long Do Appraisal Contingencies Last?

Buyers can specify in their offer how long they have to satisfy the appraisal contingency. Because sellers usually don't want to take their homes off the market for a long time while waiting for an appraisal, usually the appraisal contingency gives the buyers around 14 to 21 days to get the home appraised and determine if there is an appraisal gap to address.

Final Thoughts: Do You Need an Appraisal Contingency?

When you are making an offer to buy a home, and if you’re financing the home with a mortgage, you should likely include an appraisal contingency or at least limit your potential financial risk by providing appraisal gap coverage.

You don't want to find yourself committing to buying a home that's worth far less than you're paying (and not being able to get a loan for the full amount because of it), and appraisal contingencies protect you against that outcome.

If you are interested in buying a home and want help making sure that you pay the fair market value, get started with Freedom Mortgage today. It’s the first step on the path to homeownership!