First-Time Buyers: Why the winning offer isn’t necessarily the highest offer.

Cash is Still King.

It wasn’t too long ago that if you were competing with other offers to buy a home, the one with the highest offering price would usually win.  Assuming that all offers were roughly equal on conditions, the seller could safely opt for the highest price and not pay too much heed to how much the down payments were.   After all, money is money, regardless of whether it’s  loan or a down payment…right?   Well, that’s not necessarily the case anymore, and sellers are more and more favoring the offer with the highest down payment — even if it’s not the highest offering price.   Why?

It’s All About Risk.

You can thank the unstable economy and the new appraisal laws for throwing a new element of risk into the real estate transaction.  To better understand why, it’s important to first review what a “financing contingency” is, and how it’s impacted when you get a screwy appraisal.    When you get pre-approved by a bank to make an offer on a home, the bank will almost always include a clause in the pre-approval letter stating that “the loan approval is subject to a satisfactory appraisal,” or something similar.  Obviously, they’re not going to loan money on something that’s not worth the value.

So when the buyer fills out the Purchase Contract, they must state how much they intend to borrow from the bank and on what terms (rate, duration, etc.)   The financing contingency allows them to cancel the contract and recover their deposit IF they’re unable to obtain a commitment from the bank to fund that loan (within an agreed upon time frame.)    This last sentence is important, and it’s the crux of why a big down payment suddenly looks very favorable.

Appraisal Hell…

Banks generally only loan a certain percentage of the value of the home — today, with only a few exceptions, that percentage maxes out at 80% –  the buyer must come up with the other 20%.   So how does the bank define the value?  It’s the appraisal amount, NOT the sales price.  If those two numbers are the same, you’re golden.  If the appraisal comes in low, which has been happening more frequently lately, this is where the bigger down payment makes a difference.   Here’s why…

An Example…

Two buyers are competing for a home that’s listed at $1M (nice round number.)   Realizing he’s in a competitive bid, Buyer A offers $1,050,000 with a loan that’s 80% funded by the bank.   Buyer B only offers $1M, but is putting down 40% of his own cash?   Which offer is better?    Hmmm….

Let’s say the appraisal only comes in at $950K (believe me, this happens.)    Instead of the bank loaning Buyer A 80% of his offer price, or $840K, they’re now only going to fund $760K (80% of the appraised value of $950K.)   What can Buyer A do now?   He can:

1. Come up with the additional $80K in cash to close the deal.
2. Try to renegotiate the contract.
3. Cancel the contract (remember, the financing contingency allows him to do this since he couldn’t get his original loan.)

Needless to say, two of these three options are bad for the seller.

So what about Buyer B?  Since he only needs to get $600K from the bank, the lower appraisal doesn’t impact his offer.    He’s still $160K below that 80% threshold.  The bank is still going to loan him the $600K he needs to close the deal.   But here’s an interesting point — if he’s not happy about paying $1M for a home that’s valued at $950K, he’ll have a very difficult time canceling or renegotiating the contract on the basis of the lower appraisal.  Why?  Because he still got the loan commitment he signed up for.  Unless they included specific wording in the contract mandates that the house must appraise at the sales price, he’s obligated to complete the deal.

So which deal is better for the seller now?

The Bottom Line

Because of the sheer unpredictability of appraisals in this unstable market, the offer with the highest price may not be the best offer.   If you’re a seller, be sure to carefully read the conditions of the Purchase Contract, and understand what can happen to each and every offer if the appraisal goes sideways.   If you’re a buyer, realize that a bigger down payment may provide you with more leverage than you thought –  and quite possibly it might save you some money in the process.

Above all, be sure to consult your attorney or real estate professional to fully understand the nuances of the Purchase Contract.

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“First-Time Home Buyers” is a new category on the site that’s a resource for first-time home buyers in San Carlos, and for those who have general real estate questions.

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1. “Appraisal” doesn’t mean “Approval” anymore.
2. Home appraisals become a brick wall for some San Carlos real estate deals.
3. All-Cash Buyers and Multiple Offers: Changing the Face of San Carlos Real Estate
4. San Carlos First Time Buyers: Your First Mortgage Payments.
5. The FAQ’s on Counter Offers