Q: I’m getting an FHA loan to finance my first home. I’m in contract right now. Our appraisal is done and the house appraised for the sale price but the loan process is not yet done, although I was preapproved. My agent says the lender has to review the appraisal.
I’m confused about the difference between the loan contingency and the appraisal contingency. My agent says I should remove the appraisal contingency, but I’m not sure about that.
A: In an FHA loan scenario on today’s market, the appraisal and loan contingencies are much more closely linked than in other situations and times. This is because Federal Housing Administration-insured loans have a set of minimum standards for the condition of the homes being financed, much more so than with conventional (non-FHA) loans.
An FHA appraiser is tasked with verifying that the property does meet these condition guidelines — or, if it doesn’t, calling out the deficiencies.
In most non-FHA scenarios, the biggest issue with an appraisal is whether the property will appraise for the purchase price. With an FHA loan, though, the mortgage lender’s review of the appraisal is critical, as it can often result in additional conditions being placed on the loan, which may or may not be feasible.
For example, if the appraiser feels a deck or stairway is unsafe, or if he or she points out a missing stove or damaged linoleum, the lender may require that item to be repaired or replaced before funding the loan. If the buyer and seller in such a case cannot come to terms on how this repair can happen before closing, the deal might die.
Similarly, the loan underwriter might disagree with the comparables or other analytics used by the appraiser to support her opinion of the home’s value — and this can happen with both FHA and conventional loans.
In these cases, the underwriter can ask the appraiser to recalculate the home’s value or can simply cut the value, unilaterally. The underwriter’s job is to assess the risk any given loan presents and allow funding only for loans that fall within an acceptable level of risk.
Banks are pretty risk-averse right now, so underwriters are very tough and careful — especially in their review of the appraisal. If your loan goes south, and you stop making the payments, the underwriter wants to be super sure the bank can recover what it lent you from the property itself.
Now, to the basics underlying your question. A contingency is simply your right to bail — your right to back out of the contract, for a certain reason. Many states’ real estate purchase contracts include contingencies for inspections, appraisals, financing (loan), insurability and many other grounds on which a buyer can legitimately back out.
Most contracts articulate these contingencies in a series of paragraphs with default timelines and fill-in-the-blank alternatives to the default, empowering buyers and sellers to negotiate a customized contingency removal schedule based on when the buyer believes he or she will be ready to remove a given contingency, and when a seller requires the certainty of that contingency removal.
Sometimes, all the contingencies run shorter or longer than the default, but all of them run on the same timeline. Other times, the various contingencies are set on different deadlines.
Once the parties sign the contract, the buyer and her representatives immediately launch a series of due diligence activities to get the buyer the information she needs to know about whether to exercise or remove her contingencies.
That information typically includes details of the home’s condition (goes to the inspection contingency), the appraised value of the home (appraisal contingency), and the final approval of their financing (loan contingency).
When the timeline for any given contingency is up, the buyer has the option to exercise a contingency (canceling the deal and, usually, recouping the deposit money), or remove it (indicating that the buyer intends to move forward with the transaction).
In California, for example, when a contingency deadline arrives, the buyer who wants to move forward must actually sign a document that removes their contingency.
In most cases, if the buyer elects to back out of the transaction after proactively removing their contingencies, their earnest money deposit is forfeited to the seller as "liquidated damages," avoiding the need for a lengthy court dispute, but penalizing the buyer by tens of thousands of dollars in many cases.
The buyer who wants to back out of the contract, exercising one or more contingencies, must sign a document canceling the deal.
But often, a buyer who would like to move forward with buying the home and closing the deal simply doesn’t have the information she needs to be comfortable removing a contingency when the time comes. Your case is a perfect — and not uncommon — example.
New federal appraisal and disclosure guidelines are making appraisals take longer than before to come in, but buyers’ and sellers’ agents haven’t quite yet fully adjusted their expectations of how quickly the buyer will be equipped to remove contingencies.
Your appraisal has come in, and at the agreed-upon purchase price. But the lender’s underwriter has not yet given you the final lending green light because its review of the appraisal is still pending.
Technically speaking, the appraisal contingency allows you to back out of the deal if the home doesn’t appraise at the purchase price. The loan contingency allows you to back out if you are unable to secure financing at the terms you specified in the offer.
Technically speaking, your agent is correct that it makes sense to remove your appraisal contingency, while keeping your loan contingency in place until the lender’s review of the appraisal and of your file is complete.
What I would recommend is a two-part strategy. First, your agent should inform the seller’s agent, verbally and in writing, that you are removing the appraisal contingency (because the appraisal has come in at the purchase price) but keeping the loan contingency in place until the lender’s review of the appraisal is complete.
If your loan contingency timeline is up, you should also request an extension of time on that contingency and closing, if needed — fortunately, most underwriters require only 48 or 72 hours after they receive the appraisal to give you the results of that review.
I have seen some buyer’s brokers who are very concerned about removing the appraisal contingency remove it "subject to" the lender’s approval of the appraisal.
To my mind, this is unnecessary and redundant of the loan contingency, and may not actually constitute a true "removal" of the appraisal contingency at all. However, it might serve as the sign of progress and good faith that would make a seller comfortable agreeing to the extension of your other contingencies and/or closing date, if necessary.
Tara-Nicholle Nelson is author of "The Savvy Woman’s Homebuying Handbook" and "Trillion Dollar Women: Use Your Power to Make Buying and Remodeling Decisions." Tara is also the Consumer Ambassador and Educator for real estate listings search site Trulia.com. Ask her a real estate question online or visit her website, www.rethinkrealestate.com.
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