In the last couple of years, we have seen a rapid increase in home prices, and in some Ontario cities, prices nearly doubled over the course of the COVID-19 pandemic. After almost two years of consistent price increases, the housing market is finally starting to show signs of cooling off.
This cooling could be a great sign of relief for renters or first-time home buyers looking to get into the housing market but haven’t been able to do so due to the recent pricing environment.
One thing home buyers need to be aware of, though, is that home appraisals could potentially come in at lower values than what their purchase agreements read. During the past couple of years, buyers have become accustomed to having to out-bid other prospective buyers, or bidding amounts substantially over the home’s list price, in an effort to have their offer accepted, or even just considered. In addition, many buyers have not been putting finance conditions on their offers, all the while, obtaining financing behind the scenes. This was done in an attempt to frame their offers in the most attractive light possible.
The potential problem with this though, is that when the housing market starts to cool off, and appraisals begin to come in lower than anticipated, in essence, the home is not worth what you have agreed to pay. In turn, lenders will only finance you based off of the lesser of the two amounts. This will cause a shortfall in financing that you will need to bridge with increased down payment. So, what happens in this situation? This blog is designed to review what your options will be in the event that this happens to you, or how to best prevent this from occurring in the first place.
As previously mentioned, during the recent pandemic, it became the norm to offer anywhere between $100,000 – $200,000 over the asking price of a home in order to have a chance of getting your offer accepted. Interest rates were so low that everyone wanted to take advantage of the decreased cost of borrowing, and housing budgets were stretched to their limits. Now, with interest rates on the rise, the demand for housing is decreasing, and this decreased demand should start to lower the pricing.
This is where things get tricky—consumers are still overbidding on homes out of custom, but appraisals are starting to come in lower than those previously obtained on similar homes.
Let’s say you put in an offer on a home for $500,000 and it gets accepted. That seller is expecting yield $500,000 from this sale. Now, an appraisal is ordered, and it comes back at $450,000, which is $50,000 less than the purchase price. Banks will only lend based off of the purchase price or appraised value, whatever is lesser. In the scenario described, this means lending based off of $450,000 since the appraisal is the lesser of the two values. The agreement you’ve entered, though, warrants the seller receiving $500,000 regardless of appraisal results.
In order to proceed with the purchase, if you did not put a finance condition on your offer, you are going to be required to come up with the $50,000 shortfall, in addition to your already planned for down payment and closing costs. So, in this case, if you were putting 10% down, your down payment will now be $45,000 (based on the appraised value), and the additional $50,000 to bridge the gap. You will also need the lender and/or insurance party, to be comfortable with the revised situation.
An additional $50,000 can be a lot of money to come up with unexpectedly. If you do not have access to funds to cover this gap, here are some of your options:
3. Obtain a gift from a family member: You might not have the cash to cover the difference, but a family member may. The benefit of this method versus a borrowed down payment, is that you would not have to factor in any new debt repayment into your debt servicing. The family member supplying the gift must be aware that they will need to sign a gift letter, stating that the funds are not repayable, and may need to share up to three-months of their bank statements as proof of funds on deposit.
Unfortunately, if you don’t have the funds to pay the difference, or one of the above options isn’t available to you, the seller may opt to seek legal recourse against you for their loss/damages. This potential outcome is why it is important to look at comparable home sales in the area, use a reputable realtor or information source, obtain a pre-approval in advance, and familiarize yourself with the home buying process prior to entering into an agreement to purchase a home.
Ultimately, the best way to protect yourself from facing legal ramifications would be to put a finance condition on your offer. This means that for whatever reason you cannot obtain financing to move forward with the purchase, you can back out of the sale with no repercussions during the allotted time frame outlined in your agreement. Sellers, though, may not favour your offer due to this condition versus condition-less “cash” offers. As the market slows, however, this may become less of a deterrent.
If you find a home that you love, and your realtor is suggesting you make an offer without any finance conditions due to a high volume of bidders, you could include a condition referred to as “satisfactory home appraisal” to your offer. To a seller, this may be a less daunting obstacle than a potential purchaser not having their finances in order. This condition will allow you to cancel the sale agreement in the event that the appraised value does not yield the warranted amount of the purchase price or greater.
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