How Does an Appraisal Contingency Work?

An appraisal contingency serves as a protective measure for homebuyers within a real estate contract. It establishes a condition that allows the buyer to proceed with the purchase only if the property’s appraised value meets or exceeds the agreed-upon purchase price. This clause safeguards the buyer from overpaying for a home and helps ensure that the property’s value adequately supports the amount of the mortgage loan being sought. It acts as a financial safety net, providing an avenue to renegotiate or withdraw from the transaction.

Defining the Appraisal Contingency

An appraisal contingency is a specific clause integrated into a real estate purchase agreement. Its primary purpose is to shield the buyer from acquiring a property for a sum greater than its independent fair market valuation. Mortgage lenders typically base the maximum loan amount on the appraised value, not the sale price. If a home appraises for less than the contract price, the lender will only finance up to the appraised value, leaving a potential gap for the buyer to cover. The contingency ensures that if the appraisal determines the home’s value is less than the purchase price, the buyer can renegotiate or terminate the contract and recover their earnest money.

The Appraisal Process and Its Impact on the Contingency

The appraisal process typically begins once a buyer’s offer has been accepted and a purchase agreement is signed. The mortgage lender initiates the appraisal, often selecting a state-licensed or certified appraiser. This independent appraiser provides an unbiased estimate of the home’s fair market value. During the appraisal, the professional inspects the property’s interior and exterior, noting its condition, features, and upgrades.

They use the sales comparison approach, analyzing recent sales of comparable properties (“comps”) in the immediate area. The appraiser compiles a detailed report, shared with the lender and buyer within a few business days. The cost, typically $300 to $600, is usually borne by the buyer.

The outcome of this appraisal directly dictates the status of the appraisal contingency. If the appraised value matches or exceeds the purchase price, the contingency is satisfied. However, if the appraisal comes in lower, it triggers the contingency, creating an “appraisal gap” and activating the buyer’s options.

Navigating Outcomes and Buyer Options

Upon receiving the appraisal report, several scenarios can unfold, each with distinct implications for the buyer. If the appraised value is equal to or greater than the agreed-upon purchase price, the home purchase proceeds as planned, as the lender is comfortable financing the loan amount. In such cases, the buyer gains immediate equity if the appraisal is higher, as they are paying less than the property’s assessed market value.

A more complex situation arises when the appraisal comes in lower than the agreed-upon purchase price. Under the protection of an appraisal contingency, the buyer has several options. One common approach is to renegotiate the purchase price with the seller, asking them to lower the price to match the appraised value or to meet somewhere in the middle. This negotiation leverages the appraisal as objective evidence of the property’s value.

Another option for the buyer is to cover the appraisal gap out-of-pocket by bringing additional cash to closing. This means paying the difference between the lower appraised value and the original purchase price in cash, on top of the down payment and closing costs. If renegotiation is unsuccessful and the buyer is unwilling or unable to cover the gap, the appraisal contingency allows the buyer to terminate the contract. Exercising this right typically enables the buyer to receive their earnest money deposit back, avoiding financial penalty for withdrawing from the deal.

Considerations for Waiving the Contingency

Waiving an appraisal contingency means the buyer agrees to proceed with the purchase regardless of the appraised value, assuming the risk if the appraisal comes in below the contract price. This decision is often made in highly competitive real estate markets where sellers receive multiple offers. Removing the contingency can make an offer more attractive to a seller, signaling greater commitment and potentially leading to a quicker closing process.

However, waiving this protection carries significant financial risks for the buyer. The most prominent risk is the “appraisal gap,” where the buyer becomes responsible for paying the difference between the lower appraised value and the agreed-upon purchase price in cash. For example, if a home is offered at $400,000 but appraises at $380,000, the buyer would need to bring an additional $20,000 to closing that the lender will not finance. If the buyer cannot or will not cover this gap, and a financing contingency is not in place, they risk losing their earnest money deposit, which typically ranges from 1% to 3% of the purchase price.

Furthermore, waiving the contingency means the buyer could pay more than the home is objectively worth, potentially leading to immediate negative equity. This can affect future refinancing options or the ability to recoup the investment if the property needs to be sold sooner than anticipated. While cash buyers might consider waiving the appraisal as they do not require a lender, buyers relying on a mortgage will still face the lender’s appraisal requirements, even without a contingency. The lender’s decision to finance is always based on the appraised value, making the buyer’s financial exposure substantial if the value falls short.