You're reading this because you are, inevitably, looking for a home in an area where securing one seems impossible. By now, you've probably put in one or two reasonable bids for a property, just to see someone swoop in with a cash offer or paying above the asking price to seal the deal. That likely led to you putting a third and fourth UNreasonable bid on a property, maybe looking in the mirror or at your partner and wondering if you'd lost your mind offering that much ... and it still didn't matter. Someone went even higher and got the house anyways.
Here's the thing though: even after an offer is made, a home typically has to be appraised to find it's market value. And in red hot markets where offers come in fast and high, we are seeing more and more buyers who end up offering more for than the house than an appraisal would show that it's worth. So just in case you find yourself in this scenario, where you've had a bid accepted and later found out the home didn't appraise for the amount you needed, let's cover what happens next.
Hurdle #1: The Amount Over The Appraisal
The first hurdle in making an offer in a hot market, knowing you'll have to go over the asking price and potentially the appraised value, is just how far over you go.
Home appraisals not only take into consideration the features of the home when assessing value, but also the recent sales of comparable homes in the area. And one or two home sales isn't enough to establish a trend; an entire area or zip code's average sales price may need to increase before appraisers will move the needle. This process can be slow, whereas in some markets, a home's asking price can go up $50,000 over the course of a weekend.
Unfortunately, a lender is not going to let you borrow more money for a mortgage than a house is worth. If an appraisal comes in for $100,000, a bank won't let you borrow $125,000 just because that happens to be a competitive offer. Why? Because lenders protect themselves first. In the event you default on your mortgage, the bank tanks ownership of that property. They may then seek to turn around sell that property on the open market, which would be difficult if they gave you more money for the home than it was worth.
In scenarios where you end up making an offer and the appraisal comes in lower the offer, YOU make up the difference. In CASH.
Let's look at an example of a family hoping to buy a home that puts in an aggressive, $550,000 offer for a home that eventually appraises for $500,000:
The $50,000 gap between the offer and the appraisal must be paid in cash by the potential buyers. But that's only the first hurdle ...
Hurdle #2: The Loan To Value Requirement
Buying a house when the appraisal comes in below the asking price is not as simple as paying the difference. Each type of mortgage has a maximum percentage of the underlying home's value that they will extend to the borrower as a loan. This percentage, also called Loan To Value (LTV), functionally tells the borrower the minimum down payment they must make for their mortgage. As an example, a loan product with a max LTV of 90% means the borrower must make a minimum down payment of 10%.
Max LTV is the second hurdle that comes into play when an appraisal comes in below the offer price. Why? Because unless you have a special loan product such as the Physician's Loan - more on that later - lenders will not let you borrow 100% of your home's appraised value for your mortgage. In addition to paying the difference between the asking price and the appraised value, the borrower must also pay enough to get within the loan product's required LTV percentage.
Going back to our example, our borrower placed a $550,000 offer on a home that ultimately appraised for $500,000.. We've established that they're responsible for the $50,000 difference, which must be paid in cash. Now let's assume the mortgage they plan to secure has a max LTV requirement of 90%:
At the required LTV, the maximum mortgage the borrower can receive on a $500,000 home is $450,000 (90% LTV). This requirements means in addition to the $50,000 cash the borrower paid for the gap between the appraised value and the asking price, they must also make a $50,000 down payment, meaning $100,000 in cash must be paid at closing (not including closing costs!).
You're probably starting to see how things can get out of hand quickly. And it begs the question ...
Does It Ever Make Sense To Buy A House When The Appraisal Comes in Low??
The short answer is YES. Sometimes you have to make the best of a s#%tty situation. Given certain market conditions, there are a few scenarios - or a combination of these scenarios - where I feel an offer above the appraised value.
Your Lender Waives The Appraisal
Let us first address a little-known truth: some lenders will waive an appraisal! It's rare, but it happens. In my experience, it's most likely to occur when the mortgage is being offered by a smaller, more aggressive lender, and/or the loan is being given to a customer with whom the lender has an extensive history. If you have a client with a couple hundred thousand in deposits at a local bank and they've used them for 2 or 3 loan products in the past, they may be approved for a new loan without an appraisal at all, meaning the lender trusts the borrower so much they don't even investigate how inflated the asking price is above the home value.
As a borrower, should you be given this option, you still want to do your own due diligence to ensure the asking price is not too high over the home's value. There's a difference between taking advantage of this leeway responsibly, and being reckless. Being reckless could lead to you being stuck in a house that is woefully underwater, meaning the home value is less than what you owe. When you're underwater in a home, there are functionally only three options you have: 1.) Stay in the home and hope that it appreciates in value, giving you the ability to gain equity, 2.) stay in the home whether or not it stays underwater, and simply pay down the mortgage, or 3.) sell the home as a short sale. However the odds of # 1 happening, the home appreciating in value, should significantly improve if the next scenario is also true.
You're In A Red Hot Market
We've covered that one reason asking prices can consistently exceed appraised values in some markets is that home comparisons and appraisers haven't kept up with the pace of the area's increases in home value. However, if you're seeing this happen consistently and end up buying a home for over the appraisal, the odds may be strong that the appraisal value eventually catches up to your sales price, ensuring that you're not underwater in your new home. It's not ideal, but realistically, there are home markets where if you don't go way above asking, you simply won't get the home. And at a certain point, you have to either accept that or do what you have to do.
There Are Other Loan Products Available
It's worth noting that there are dozens of different mortgage products out there, and each has different requirements for borrowers seeking approval. Requirements in terms of documentation that must be provided, the occupation in which you must work in some cases, and most importantly, requirements for a minimum down payment. As an example, an FHA loan has strict requirements in terms of the credit score requirements of borrowers, and a minimum down payment based on said credit scores (10% for borrowers with scores below 580, 3.5% for those above 580). For less conventional products not tied to government programs, lenders can be more flexible in the terms they set, although there are certain federal regulations that must be followed. Your down payment requirements for one mortgage product can be radically different with another. You may have one mortgage that requires you to make a 20% down payment - 80% LTV - or risk having PMI added to your payment, while another may allow a 10% down payment - 90% LTV - with no PMI. One loan may require a max LTV of 90% while a different product allows 95%. If you've placed an offer that ends up being above the appraised value, consider asking your lender if there's an available product that allows a larger LTV. In doing so, you can potentially decrease the amount below the appraised value you must bring as a down payment in order to get within the LTV guidelines. Speaking of these specialty loans, a special group must be addressed.
You're a Physician
We've talked about The Physician Loan (also called the Doctor Loan) in the past. It's a special type of mortgage just for physicians and dentists. The Physician Loans available in many states allow borrowers to receive mortgages for the full value of the house, meaning 100% LTV. Even in states where 100% LTV is typically not allowed, such as California and Texas, 95% LTV is still attainable depending on an applicant's credit scores. If you're a physician or dentist bidding on a home over the appraisal, the allowable LTV for a Physician Loan minimizes the amount of cash you bring to the table. But remember our rule; straddle the line of taking advantage and being reckless. If you go too high over asking and the home values don't continue to appreciate, you will be in a home that's underwater.
You Build In A Failsafe
You're in a competitive market. You may have to go above asking, but you can still build in a failsafe. Let's go back to our initial offer, $550,000. In our initial example, the home appraised for $500,000. But right now, we'll wipe that away and assume that before the appraisal, our prospective home buyers put a contingency in their contract that they will only go $35,000 above asking for a max offer of $550,000. Now let's take two different appraisal amounts and see what the impact would be to the offer if the sellers accepted:
- $500,000: even though the buyers were willing to spend $550,000 on this house, they also said they would not exceed $35,000 over asking. Since the sellers accepted the contract, this means the house would be sold for $535,000, $15,000 below what the borrowers were willing to pay. They are, however, obligated to pay the $35,000 over the appraisal. The sellers must also accept this offer, or either side will be in breach of contract.
- $525,000: in this scenario, the $35,000 offer by the buyers would mean a sale price of $560,000 ($525,000 + $35,000). Because their contingency says their max bid is $550,000, they can walk away from the offer if they so choose, and all they are likely to lose is their earnest money. The borrower may prefer to release them anyways, thinking they can get a better offer with the higher appraisal. Or they can draw up a new offer with the same party at a different price point. But the seller's obligation to buy the home at the appraisal plus $35,000 has been nullified by their max bid contingency.
You Can Afford It!
This is the last, but most obvious consideration. If the market is what it is, and you can afford the extra down payment and the mortgage on the house for which you're bidding, don't overthink it! Just make sure you've run your numbers and are actually sure you can indeed afford it.
I hope this shed some light on the cons of bidding on a house above its' appraised value, and the pros that can make doing so worth it in some cases. It's a crazy market out there, and I wish you the best of luck as you navigate it!