One of the most common questions Jen Bell of Premier Mortgage Resources hears is, “What happens if the appraisal comes in low?” This has become a regular occurrence, and every buyer who is financing the purchase of their home should be prepared for this possibility.
The Portland real estate market is struggling with ultra-low housing inventory, which is driving prices higher. At the same time, appraisers and banks now follow more stringent guidelines to guard against the inflated valuations common during the housing bubble. Home prices are now rising much faster than typical appraisal methods allow for, since they are based on past sales. Since nearly every desirable property receives multiple offers, many buyers are escalating their offer price first, and asking questions later.
So what happens if you win the bid but the home doesn’t appraise? As Bell explains, it all depends. In the following case study, she outlines four typical scenarios she sees, spelling out the the math, the consequences, and the opportunities that apply based on the situation.
Buyers with 20% or more cash down, or additional funds available
“If a buyer is putting 50% down on a property and the appraisal comes in low, they can agree to purchase the property knowing they are paying more than its current market value,” Bell reports. “Depending on the difference between the sale price and the appraised value, it may not even change any of the loan’s terms. The loan to value ratio (the percentage of your loan in comparison to the value of the property) will simply adjust.”
Loan to Value Ratio:
The Percentage of a loan compared to the value of a Property
For instance, a buyer may agree to pay $400K for a house and have a $200K down payment, but the appraisal might come in at $375K. The buyer can agree to pay difference to the seller between the sale price and appraised value by contributing the $25K in cash from the down payment funds. This would lower the down payment to $175K. Or the buyer with the means can bring in an additional $25K from another source to complete the purchase. Even if they lower the down payment amount, the loan to value ratio changes from 50% to 46%, a negligible difference.
There are possible effects, however, if the loan to value ratio slips above 80%. For instance, if a buyer agrees to pay $300K for a property with $60K down, or 20%, but the property appraises for $285K. The buyer can reduce their down payment to $45K and agree to pay the additional $15K to the seller. However, this means that instead of 20% down, the buyer’s down payment is now roughly 16% ($45,000 ÷ $285,000) and the loan is now 84% of the home's value.
LOAN TO VALUE RATIO HIGHER THAN 80%
$300,000 agreed sales price, with $60,000 buyer down payment
$285,000 appraised value
$45,000 reduced down payment as result of low appraisal
$15,000 paid to seller (difference between original and reduced down payment) to reach sale price
$240,000 ÷ $285,000 =
84% Loan to Value
For loans above 80% Loan to Value, Lenders may require:
Mortgage Insurance added to monthly payment
OR a higher interest rate on the loan.
For most lenders, having less than a 20% cash down payment triggers other requirements. Specifically, buyers in this situation might be required to add the cost of mortgage insurance into their monthly payment. The buyer might also be required to pay a higher interest rate.
Buyers with less than 20% down, and no additional cash reserves
If the buyer has a smaller down payment and the property doesn’t appraise, Bell immediately thinks, “how much wiggle room does the buyer have?” In a balanced market, where buyers have more leverage, “a low appraisal might result in a seller agreeing to lower the sales price. But in today’s competitive situations, buyers often don’t even want to ask the seller to negotiate.”
If a buyer is putting 5% or 10% down and the appraisal comes in low, there are few options since these are the buyers least likely to have extra cash on hand to make up the difference between the appraised value and the sales price.
This is where the math gets really tight.
For example, if a buyer agrees to pay $300,000 for a house and is putting $15K, or 5% down, what happens if the appraisal comes in $290,000? The lender will only finance a mortgage up to 95% of the $290,000, or in this instance, $275,500. The buyer has to bring in the extra $9,500K to reach the agreed price of $300K.
Low Appraisal with a 95% Loan:
$300,000 sales price
$15,000 down payment
$290,000 actual Appraised Value
$290,000 x 95% = $275,500 maximum loan amount
With an appraised value of $290,000, the required 5% downpayment is lowered to $14,500.
$14,500 down payment + $275,500 loan = $290,000 Total
Buyer has reduced down payment by $500 to qualify for $290,000 loan, but must contribute additional $10K to seller to reach $300,000 agreed sale price.
Another possibility is to switch to a different loan product if the buyer qualifies—one that will lend up to 97% of the property’s appraised value. The math looks a little better: For a $290K appraised value the buyer must contribute 3% or $8,700 down. That frees up $6,300 of the original $15K down payment to give to the seller. But even with this, that puts the total amount of funds at $296,300. That’s $3,700 short of the agreed $300K sales price. In this market, the seller is likely to find another buyer who will meet their price.
A buyer’s earnest money is protected if the appraisal come in low. Lines 72-78 of the Oregon Residential Sale Agreement specifies that the appraisal “shall not be less than the Purchase Price.” If the parties do not come to agreement on price as a result of a low appraisal, the transaction is terminated. The buyer’s earnest money is returned and the seller puts the house back on the market.
Using the Appraisal Contingency as a Bargaining Chip
The Sale Agreement also specifies that the Financing Contingencies, including the appraisal, “are solely for the Buyer’s benefit and may be waived by the Buyer in writing at any time” (Line 76). For some buyers, this offers an opportunity to win a competitive bid.
Consulting with their mortgage broker and realtor, buyers can prepare for the possibility that the house they want may not appraise. The buyer may choose to include language in their initial offer that removes the appraisal contingency, signaling they have additional funds to bring to the transaction if the appraised value is lower than the amount the buyer is willing to pay.
Typical language included in the sale agreement may read:
“Should the property not appraise, the buyer will provide the additional funds needed to close.”
“Buyer waives the appraisal contingency.”
For well-financed buyers, this changes the terms of their offer and gives the seller assurance there will be a smooth path to closing.
A final example protects the buyer from getting too far out of line with the current appraised value:
“Buyer will purchase the home for $700k if the home appraises for at least $650k.”
This language protects the buyer to a certain degree, putting a floor under the appraised value of the property. If the home appraisal doesn’t meet the criteria, the seller and buyer will need to negotiate the price or terminate the transaction. In highly competitive situations, this hedge leaves the door open for a more aggressive buyer to eliminate the contingency altogether. It’s all a matter of how much risk the buyer is willing to absorb.
What to Consider When Paying More than the Appraised Value
Bell sees a lot of loans come across her desk, and asks buyers to consider the long-term implications before agreeing to pay more than the appraised value in the heat of competition.
“You should consider the number of years you plan to live in the house. Does buying a house that under-appraises make sense for a buyer who plans to move to Colorado in 3 years? In that case, the buyer is really betting the market will continue to improve rapidly, as it is now.” Any abrupt cooling in the market could make it nearly impossible to get their entire investment out of the property. For speculators, those who plan to flip a house in the very near term, the risks are always greatest.
“Typically,” Bell continues, “clients I work with are raising families, starting families, and need a place to settle down for many years. For these buyers, purchasing a home that under-appraises makes more sense.”
“No matter the market, if you keep a home long enough the owner should see a return on investment.” Bell knows this from her own experience. “I was a buyer who purchased a property in 2006, at the market peak, and paid a premium for it. I stayed for 10 years to make sure I saw a return.”
No one has a crystal ball when it comes to the real estate market. Bell herself can’t predict when the Portland market may swing the other way, becoming more favorable to buyers. But whatever the conditions, she is there to provide strategic thinking and the lending tools buyers need to navigate the market today.