When buying a home, you want to ensure a fair deal. That’s where contingencies come in. A contingency is a condition that must be fulfilled for the purchase contract to remain valid. If the contingency isn’t met, the buyer can withdraw from the sale without any financial penalty.
You can include several contingencies in a purchase contract, each designed to protect you during home-buying. One of the most important is the appraisal contingency, which ensures you’re not paying more than the property is worth.
What is a Contingency?
A contingency allows the buyer to leave the purchase without losing their deposit if certain conditions aren’t met. Contingencies can cover many aspects of the home-buying process, but the three most common are the appraisal contingency, financing contingency, and home inspection contingency.
These contingencies offer protection and peace of mind, especially if unexpected issues arise during the purchase process. Let’s detail each one, starting with the appraisal contingency.
The Appraisal Contingency: Ensuring You Don’t Overpay
Appraisal contingency is one of the most crucial protections in a home purchase agreement, mainly if you rely on a mortgage. Most lenders require an independent appraisal of the property to confirm its market value before they approve a loan. A third-party appraiser performs the appraisal, assessing the home’s condition, comparable sales, and other market factors to determine its fair market value.
Why is the Appraisal Contingency Important?
Lenders want to ensure they’re not lending more money than the property is worth. If the home’s appraised value comes in lower than the agreed-upon purchase price, it creates a gap between what the lender is willing to finance and what the buyer has agreed to pay.
With an appraisal contingency in place, you’re protected. If the appraisal comes in lower than expected, you have options. You can:
- Negotiate a lower price with the seller: The seller may agree to lower the sale price to match the appraised value, avoiding the risk of the deal falling.
- Walk away from the deal: If a new price isn’t agreed upon, the appraisal contingency allows you to cancel the contract and return your deposit.
- Make up the difference: If you want the home and the seller won’t lower the price, you can increase your down payment to pay the difference out of pocket.
Example Scenario:
Let’s say you’ve agreed to buy a home for $500,000, but the appraiser values it at $480,000. The lender will only finance up to the appraised value, leaving you with $20,000 to cover if the seller won’t adjust the price. Here’s where your appraisal contingency protects you. You can leave the deal without losing your deposit if you can’t negotiate a price reduction.
The Financing Contingency: Protecting Your Loan Approval
Another essential contingency is the financing contingency, which allows you to back out of the deal if you cannot secure financing. Most homebuyers rely on a mortgage to complete their purchase, and while pre-approval gives you an estimate of what you can borrow, your loan isn’t guaranteed until it goes through the entire underwriting process.
How the Financing Contingency Works
With a financing contingency in place, your purchase depends on your ability to obtain a loan for the total amount needed. If your loan is denied or the lender approves a lower amount than expected, you can cancel the contract without penalty. This contingency provides critical protection if your financial situation changes or issues arise during underwriting.
Why You Might Need a Financing Contingency:
- Job Changes: Your loan approval could be affected if you change jobs, take on new debt, or experience a shift in income during the loan process.
- Credit Issues: Any changes to your credit score between pre-approval and closing could affect your final loan approval.
- Loan Terms: Some loans have specific requirements, such as property condition or appraisal value. If these requirements aren’t met, the loan may not go through.
The Home Inspection Contingency: Avoiding Major Repairs
The third major contingency is the home inspection contingency, which allows you to have the property thoroughly inspected by a professional before completing the purchase. This contingency ensures the home is in good condition and free of major structural or safety issues.
What Happens During the Home Inspection?
A licensed home inspector will evaluate the property, checking for issues like:
- Roof damage or leaks
- Plumbing or electrical issues
- Structural problems like foundation cracks
- HVAC system condition
- Termite or pest infestations
- Water damage or mold
After the inspection, you’ll receive a detailed report highlighting any potential issues with the home. If significant problems are found, you can use the contingency to:
- Negotiate repairs: Ask the seller to fix the problems before closing.
- Request a price reduction: If repairs are needed, you can negotiate a lower price to account for the cost of fixing the problems yourself.
- Walk away: If the issues are too significant and the seller isn’t willing to negotiate, the home inspection contingency allows you to cancel the contract and return your deposit.
The home inspection contingency gives buyers peace of mind, ensuring they’re not taking on a property with hidden defects or expensive repair needs.
What Happens If the Appraisal Comes Too Low?
If the appraisal on your new home comes in lower than the agreed-upon purchase price, there are several potential outcomes, depending on whether or not you have an appraisal contingency in place.
Without an Appraisal Contingency
If you waive the appraisal contingency—often done in competitive markets to make your offer more attractive—you’ll be responsible for covering any shortfall between the purchase price and the appraised value. If the appraisal is $20,000 less than the sale price, you’ll need to come up with that extra $20,000 out of pocket.
With an Appraisal Contingency
If your contract includes an appraisal contingency, you have several options to move forward:
- Negotiate a Lower Price: The seller often agrees to lower the sale price to match the appraised value. This can be the simplest solution if both parties are motivated to complete the transaction.
- Pay the Difference: If the seller won’t negotiate the price and you still want the home, you can increase your down payment to cover the difference.
- Walk Away: If neither of the above options works, you can invoke the appraisal contingency to cancel the contract and have your deposit returned. This protects you from overpaying for a home and taking unnecessary financial risks.
Balancing Contingencies with Market Conditions
While contingencies are designed to protect buyers, they can also make your offer less attractive in competitive markets. In hot real estate markets where bidding wars are common, some buyers waive contingencies, including the appraisal contingency, to strengthen their offers.
The Risks of Waiving an Appraisal Contingency
Waiving the appraisal contingency can be risky, leaving you vulnerable to paying more for the home than it’s worth. If the appraisal comes in low and you don’t have this protection, you’ll be responsible for making up the difference, which could strain your budget.
However, in a seller’s market, leaving out an appraisal contingency might give you a competitive edge over other buyers, signaling to the seller that you’re willing to take on more risk to close the deal. It’s crucial to weigh the risks and rewards based on your financial situation and the current market conditions.
The Bottom Line
An appraisal contingency is a critical safeguard in home-buying, protecting you from overpaying for a property. By ensuring the home is appraised at or above the purchase price, this contingency gives you leverage to renegotiate the price or walk away if the appraisal falls short. While waiving the appraisal contingency might make your offer more competitive, it also increases your financial risk. Understanding how contingencies work allows you to make informed decisions and protect yourself during your home purchase.
FAQs
How do you get around appraisal contingency?
If the appraisal results are below the agreed amount, you can waive the appraisal contingency or negotiate with the seller to lower the price.
What is a financing contingency?
A financing contingency protects the buyer by allowing them to withdraw from the deal if they are unable to secure a loan.
What is the appraisal addendum?
An appraisal addendum outlines specific terms in the contract regarding how appraisal results will impact the sale, such as price adjustments or deal termination.