Bidding wars: appraisal gaps and escalation clauses

You found the home, but you are not the only one. When there are several offers, it is easy to push the price up in the heat of the moment. The problem is that the lender does not lend on what you offer, but on what the home is worth in the appraisalhome appraisalAn appraisal is a written document that gives a professional appraiser's opinion of how much a property is worth. The lender orders it before approving the mortgage, because the home is the loan's collateral and the lender does not want to lend more than it is worth. If the appraisal comes in below the price you agreed, the bank bases the loan on the lower value and you will have to cover the difference, renegotiate the price or walk away if your contract allows it. An appraisal is not an inspection: it measures value, not the home's condition.See the full definitionClose. This guide explains what it costs to offer too much, how an escalation clause works and what you risk if you give up your protections to win. Our guide What if the appraisal comes in low? covers what to do once you have the appraisal in hand.³

Of the price or the appraisal: that is the value the lender uses for your loan

The lower¹

With its addenda, including an escalation clause, goes to the appraiser

The whole contract⁴

Have a clause that protects your deposit if the appraisal does not reach the price

FHA and VA²

What the appraisal gap is and who pays it

The appraisal gapappraisal gapAn appraisal gap is the difference between the price you agreed to pay for a home and an appraisal that comes in lower. It matters because the lender measures your loan against the property's value (the loan-to-value ratio): on loans Fannie Mae buys, that value is the lower of the sales price or the appraised value. With a VA loan, for example, you can request a reconsideration of value, negotiate a lower price with the seller or pay the difference at closing. An appraisal contingency in the contract can let you renegotiate the price or walk away from the purchase.See the full definitionClose is the difference between the price you offered and the appraised value, when the appraisal comes in lower. You almost always pay that difference:

• With a conventional loan, Fannie Mae figures the loan-to-value ratioloan-to-value ratio (LTV)The loan-to-value ratio (LTV) compares the amount of your mortgage with the appraised value of the property. It is expressed as a percentage: a loan that covers almost the whole value has a high LTV; one with a large down payment, a low LTV. Lenders use it to measure risk: the higher the LTV, the stricter the requirements and the more likely you will be asked for mortgage insurance. Over time, as you pay down principal or the home gains value, your LTV falls, which can let you cancel PMI on a conventional loan.See the full definitionClose using the lower of the sales price or the appraisal.¹ If the appraisal is lower, your loan is based on that value.
• With FHA, the maximum loan is based on the adjusted value, which for a purchase is the lower of the price (less inducements) or the property value.²
• With VA, if you go ahead, the loan is capped at the lower of the price or VA’s reasonable value.⁹

In all three cases, whatever you offered above the appraisal is not covered by the loan. You put it in as cash, on top of your down paymentdown paymentThe down payment is the part of the home's price you pay out of your own pocket when you buy; the loan covers the rest. In U.S. Spanish it is also called enganche, cuota inicial or entrada. Each loan type has its own minimum: FHA requires at least 3.5% of the value, VA and USDA loans may require none, and conventional loans ask for more if you want to avoid private mortgage insurance. A larger down payment lowers the loan, the monthly payment and the total interest; many state programs help families put it together.See the full definitionClose and closing costs. The CFPB says it plainly: it is very risky to buy a home for more than its appraised value.³

That cash has to come from somewhere. If you use your reservesreservesReserves are the cash and other easy-to-cash assets you still have available after the mortgage closes. They are measured in months: how many full monthly house payments (principal, interest, taxes, insurance and association dues) you could cover with them. Under Fannie Mae's rules, they include money in checking or savings accounts, investments, the vested part of a retirement account and the cash value of a life insurance policy; personal loans and the money you use to close do not count. An eligible gift can also be used. How many months are required depends on the loan and the property.See the full definitionClose or emergency fund to cover the gap, you may be left with no cushion just as the costs of the new home begin. The how much house can I afford calculator and the down payment savings plan help you see what you would have left.

Example with real numbers

A couple who bids above the price

An example in words, not a real case, of how the gap appears.

What they offer

More than the list price, to beat other offers

What the appraisal says

A value lower than their offer

What the bank lends

It figures the loan on the appraised value, not on their offer

What they are short

The difference between their offer and the appraisal, in cash, on top of their down payment

Their options

Negotiate the price with the appraisal in hand, pay the difference or cancel if their contract allows

The rules in this example come from Fannie Mae and the CFPB.¹³ Use the closing costs calculator to see your total cash.

Run it with your numbersClosing costs

If the appraisal comes in low after you win

Winning the offer does not end the story. If the appraisal comes in low, the CFPB suggests using it to negotiate: it is strong evidence the price was above market value. If the seller will not lower the price, you may want to cancel. Depending on your contract, canceling may cost you something, but the CFPB says those costs are likely small compared with buying a home that is not worth what you paid.³

What you can do depends on what you promised in your offer. If your contract has an appraisal contingencycontingencyA contingency is a condition you add to your offer or purchase contract to protect yourself: if it is not met, you can change or end the contract and, in general, get your earnest money back. The most common are the inspection contingency, if the inspection finds problems; the appraisal contingency, if the appraisal comes in below the price; the financing or mortgage contingency, if you cannot get the loan within the agreed time; and the home sale contingency, tied to selling your current home. Contingencies are a normal part of buying, but too many can make your offer less attractive to the seller.See the full definitionClose, you have a way out. If you promised to pay the difference, or waived that condition, your earnest moneyearnest moneyEarnest money is a deposit the buyer pays when signing the purchase contract to show good faith that the offer is serious. The seller does not keep it: a neutral third party (the title company or a closing agent) normally holds it, and at closing it is applied to your down payment or closing costs. If you back out for a reason the contract allows, such as an inspection or financing contingency, you get it back; if you back out without a valid reason, you can lose it.See the full definitionClose may be at risk: it is returned if the contract ends for a permissible reason, but you can lose it if you do not perform.⁸

With FHA and VA you have a protection that does not depend on what you negotiate. With FHA, if you did not have the appraised value when you signed, the contract must be amended before closing with a clause saying you do not have to buy or lose your deposit if the value does not reach the price; you decide whether to proceed.² With VA, the escape clause does the same against VA’s reasonable value.⁹ Our FHA loan and VA home loan guides explain the rest.

The escalation clause: how it works and its pitfalls

An escalation clause is part of your purchase offerpurchase offerA purchase offer is the formal proposal you make to a seller to buy their home. Your real estate agent writes it up and sends it to the seller's agent. It includes the price you offer and the terms of the purchase: your target closing date, who pays certain fees, a deadline for the seller to respond and any contingencies, which are conditions that must be met before you buy. The seller can accept it or answer with a counteroffer, and you can accept, reject or counter again. Once both parties sign the written offer, it becomes a contract.See the full definitionClose saying you will pay a specific amount more than the highest competing offer. It may or may not have a maximum price.⁵ The Texas Real Estate Commission gives this example: paying “X amount more than the highest offer if other offers are present”.⁶

It sounds good, but the North Carolina Real Estate Commission discourages it and explains the risks:⁵

• With no cap, you may end up paying much more than you wanted.
• With a cap, the seller immediately knows your top price, and you lose bargaining power.
• The offer may not be enforceable until a specific price is written into the contract.
• The seller could invent a fake offer to drive up your price.

Also, to know how much you would pay, someone would have to show you the other offer. In North Carolina, a broker may not disclose the price or other material terms of an offer to a competing buyer without the express permission of the person who made it.⁵ That is why the Commission says the seller’s best response is usually to ask all buyers for their highest and best offers.⁵

Who writes it? A purchase contractpurchase agreementA purchase agreement is the written contract between you and the seller that is final once the seller accepts your offer and both of you sign it. It gathers the details of the sale: the names of the buyers and sellers, the total price, the real estate agent's commission, the requested closing date and the contingencies. You use it to get your loan, and it is submitted with the closing paperwork. The settlement agent pays out the money according to the contract and the loan, and whether the seller pays some closing costs is also set by the contract.See the full definitionClose is a legal document, and any change can affect your rights. In Texas, a licensed agent may not draft or add language that defines or affects the parties’ rights, such as an escalation clause, because that is the unauthorized practice of law.⁶ In North Carolina, brokers may not draft them either.⁵ Ask your agent which approved forms your state uses and what they can and cannot write for you.

And the appraiser will see it. Fannie Mae requires that the appraiser receive the complete, ratified contract with all addenda.⁴ An escalation clause does not raise the home’s value: the appraisal still measures what it is worth.

Waiving contingencies to win

In a competitive market, you may be told to drop conditions so your offer looks stronger. Before you do, understand what you lose:

• The inspection. According to the CFPB, if your contract is contingent on a satisfactory inspection, you can cancel without penalty if you are not satisfied with the results. With a serious flaw, such as a cracked foundation, you may decide not to buy, or negotiate for the seller to fix it or give you a credit, though the seller may say no.⁷ Without that condition, walking away can cost your deposit.⁸ Our guide Home inspection explains what it covers.
• The appraisal. The inspection and the appraisal are different, and you generally need both.⁷ With no appraisal contingency, if the value comes in low you will have to pay the gap or risk your deposit.
• Financing. It protects you if you do not get the loan. Our guide Preapproval vs. prequalification explains why a preapproval is not a promise.

A strong offer or a risky offer

Safer

Strong, with protections

• Preapproval ready and short deadlines
• An earnest money deposit you can afford
• A top price decided in advance
• Inspection and appraisal as conditions

More risk

No protections

• No inspection: with a serious defect, walking away can cost your deposit
• No appraisal: the gap comes out of your pocket
• Escalation with no cap: you may pay more than you wanted
• Your savings can end up tied to the offer

If you want a stronger offer, start with what does not take away your protections.

Before you bid in a competition

1. 1. Have your preapproval

   Before you search

   That way you know how much the bank lends and on what value.¹

2. 2. Decide your top price and extra cash

   Before you see other offers

   Write down the price you will not go past and how much you could add if the appraisal comes in low.³

   Try it with your numbersHow much house can I afford?

3. 3. Ask which forms your state uses

   Before you write the offer

   And whether your agent can add an escalation clause.⁶

4. 4. Check which contingencies you drop

   Before you sign

   Every condition you drop is a penalty-free exit you lose.⁷

5. 5. With FHA or VA, confirm the clause

   When you sign the contract

   The amendatory or escape clause protects your deposit.⁹

If this is you

It is your first offer and there is competition

Decide your top price first; the lender only lends on the lower of the price or the appraisal.¹

Your down payment already uses most of your savings

Bidding high can leave you with no cushion: the gap is paid in cash.³

You are buying with a VA loan

The escape clause lets you leave without losing your deposit if the price exceeds VA's value.⁹

Your agent suggests an escalation clause

Ask whether it has a cap and who drafts it; in Texas, the agent may not.⁶

You are asked to drop the inspection

Without that condition, if you find a serious defect and walk away, you can lose your deposit.⁷

Mistakes that cost you

• Mistake: Bidding high without knowing where the difference will come from.

  Instead: The loan is figured on the lower of the price or the appraisal; the gap is your cash.¹

• Mistake: Using an escalation clause with no cap.

  Instead: You may end up paying much more than you wanted.⁵

• Mistake: Asking your agent to draft any clause.

  Instead: In some states they may not; ask which approved forms are used.⁶

• Mistake: Dropping the inspection to win.

  Instead: With it you can cancel without penalty if the results do not satisfy you.⁷

• Mistake: Thinking an escalation clause will raise the appraisal.

  Instead: The appraiser sees the whole contract but measures what the home is worth.⁴

• Mistake: Believing that with FHA you will lose your deposit if the appraisal is low.

  Instead: FHA's amendatory clause lets you walk away without losing it.²

Free help

A HUD-approved housing counselorHUD-approved housing counselorA HUD-approved housing counselor works at an agency HUD has approved to provide housing counseling: independent, expert advice customized to your situation about buying a home, renting, a missed mortgage payment, a foreclosure or credit problems. The agencies usually charge little or nothing; many serve in Spanish and offer the homebuyer education course several assistance programs require. They are not lenders or real estate agents and sell you nothing. Your county page lists the official agencies with phone numbers.See the full definitionClose can help you for free or at low cost decide your top price and understand your offer; search by ZIP code on the CFPB’s website.¹⁰ Our guide HUD-approved housing counselors explains what they do. If you have a question about what your contract says, our guide Free legal aid explains how to find no-cost legal help, and How to choose a real estate agent helps you ask the right questions.

What to do this week

1. Get your preapproval and ask what value the bank lends on.¹
2. Write down your top price and the extra cash you could add without touching your emergency fund.³
3. Ask your agent for a blank offer form and read which contingencies it includes.⁷
4. Ask whether, in your state, your agent can add an escalation clause.⁶
5. If you use FHA or VA, ask to have the amendatory or escape clause explained.²