Armed with a hard-earned down payment, pre-approval from a lender, and a wish-list of what you “must” have in your dream property, window shopping for homes can be an exciting experience.
And then it happens. You find the perfect place in your desired neighborhood. Unfortunately, there are 10 others who have also fallen in love with “your” new home. And so, the bidding war begins.
Let’s say you win that battle, with the final selling price magically within your pre-approved amount as set by your lender. It is at this stage that buyers believe the hard work is over, and it is only a matter of signing a few papers to close the mortgage so you can finally get the keys to your new home. But that is not the case for some.
If an appointed appraiser assesses that the property value is less than what you offered in a high-stakes bidding war, you could be in trouble. Should this happen, your lender will only loan you as much as the home is actually valued at (minus your down payment) – not what they’d originally offered in your pre-approval.
For example, a buyer has a $30,000 (5%) down payment and is approved for a mortgage of $570,000. He/She finds a property, with a $600,000 price tag. The appraiser, however, believes the property to be only worth $575,000.
What does this mean for the buyer?
The maximum mortgage amount that the lender will provide on this new appraised value is :
95% of $575,000 = $546,250
The total amount required to close this deal is: $600,000 – $546,250 = $53,750
Amount needed to close deal – buyer down payment = Additional funds required
$53,750,000 – $30,000 = $23,750
The buyer only intended to put down $30,000 but now needs an additional $23,750 to secure a mortgage for this transaction. At this point, you have two options: borrow money from someone, or be forced to walk away from the deal (and risk losing your deposit, in the process). Not having the resources in this situation is what we refer to as “appraisal risk”.
So, how can buyers avoid this nightmare?
First, you should avoid overpaying. But how can you do this in a competitive market? A good real estate agent should understand the “real” value of the property and the neighborhood you want to buy in.
Having a larger down payment can also reduce your risk in appraisal cases. You can put less money down and use the extra cash to make up the shortfall. However, on the flip side, this means you might have to pay a higher CMHC insurance premium (premiums are mandatory for down payments under 20% and are charged in 5% tiers).
The big trouble arises when a buyer only has a 5% down payment saved and makes a firm offer to buy because then there is little room to get extra funds from their own sources; this is when a buyer has an extreme appraisal risk.
For that reason, we would never recommend any buyer enter a bidding war with only a 5% down payment. And, if they do, we suggest having a financing condition within the deal. While this puts the buyer at a disadvantage to those with a “clean” (condition-free) offer in the bidding war, it is the risk they, unfortunately, have to take if they really want that property.
Even buyers at the 20% down payment threshold face appraisal risk in bidding wars. If an appraisal comes in lower than the purchase price, the buyer then has to put down less in order to make up the shortfall, and purchase CMHC insurance when they otherwise would not have had to.
Your broker or agent cannot control what an independent appraiser values a property at. Neither can buyers. Knowing the risks before making a firm offer in a bidding war, however, can help you prepare and plan for every outcome.
Michael Distefano
Mortgage Agent and Manager of operations
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