“Buyer’s obligation to complete this sale is contingent upon an appraisal of the Premises…”
A well written real estate purchase contract will contain a clause that requires the property to be evaluated by an independent appraiser. The clause may also specify that final approval of any financing is subject to the appraiser determining an acceptable value.
Why do we need appraisals?
A little over 90% of all home sales involve financing. Lenders that offer mortgages and home loans assume a large portion of the risk associated with financing a home. The amount of risk a lender is willing to accept is called the Loan to Value (LTV) ratio. LTV is determined by dividing the mortgage amount by the appraised value of the property. For this reason, before an underwriter will approve funding on a home loan, they will require an appraisal by a qualified independent 3rd party.
Because the goal of many home sellers is to obtain the maximum dollar amount from the sale of their home they often market the property at a price that exceeds the average price of similar or comparable homes in the area.
Since purchasing a home is often an emotional experience, the home buyer having fallen in love may be willing to pay any price for the home. Sometimes more than the homes is worth on the fair market.
What is an Appraisal Contingency and how does it work?
The Appraisal Contingency is relatively simple. The property must appraise at a value that matches the financing package. So as an example suppose a borrower wants to buy a home at $100K and the buyer is willing to put down $10K. This would result in a 90% LTV or $90K of the purchase price covered by the loan. That is the amount of risk the lender is willing to approve. If the appraiser finds that the property has a minimum value of $100K then the ratios match and the loan is approved.
However, should the appraiser find that the property value is less than the $100K purchase price the LTV ratio is not met and the loan may be denied? Since the LTV ratio is determined by using the formula, loan amount/appraised value, a new value lower than the estimated $90K is all that is available to the buyer.
When the appraisal is lower than the purchase price. The buyer and seller have to resolve the discrepancy. Since the buyer’s financing will not be approved under the current agreed upon value they must rectify the situation. Some of the options are:
- Cancel the current contract and go their separate ways.
- Renegotiate the sale price to one that is acceptable to the buyer and lender.
- Seek a different financing package that will allow the sale to continue.
- Allow the buyer to deposit in cash the difference between the LTV and purchase price.
Most often, a combination of renegotiation and additional cash may bring the two parties back to agreement.
Who does the Appraisal Contingency protect?
The Appraisal Contingency is a great protection for the buyer as it helps protect them from paying too much for a home. It also protects the lender from assuming too much risk.
Since approximately 60% all mortgages offered today are owned by Fannie Mae, Freddie Mac or Ginnie Mae it helps ensure that mortgage industry as a whole remains solvent.
Are appraisals always correct?
Unfortunately, an appraisal is simply an “opinion of value”. The appraiser uses the best tools and data available to them at the time of the appraisal. Sometimes a property can be valued by two different appraisers and result in two different “opinions of value”.
To add complexity to the appraisal process the type of home loan the buyer is using may require the appraiser to use different criteria when determining the value. So as an example, an FHA backed mortgage may have stricter criteria than a conventional loan with regard to comparing the value of a property.
What if I am paying cash?
Home buyers that are purchasing without a mortgage may not be required or choose to use an Appraisal Contingency. This often makes the cash offer more attractive to home sellers. But just because you are not required to purchase an appraisal it may still be good practice to have the property appraised to ensure that the value is consistent with the market. No one likes overpaying.
In short, appraisals help protect buyers and lenders in the short term. They also help moderate a volatile market by keeping values consistent with the other recent sales. Despite the fact that we often rail against the sometimes bewildering appraisal process, they are an important part of the real estate business.
Joe Domino is a Realtor® serving the Phoenix & Scottsdale metro area. You can find more great information by visiting his website at www.Scottsdale-AZHomes.com.
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