If you’ve been paying attention to the news anytime in the last two year, I’m sure you’ve heard how crazy the housing market is today. House prices are at all time highs, and even with higher interest rates, home price growth is only decelerating, not decreasing. If you are like me and purchased a new home during this time period, you are very aware of how hard getting offers accepted has been. Even offering $20K to $40K over asking wasn’t even enough to have an offer considered. That might be because more goes into an offer than just the purchase price. Many home sellers look at different conditions within an offer before making a choice. So, for all the new home buyers out there, we need to cut through the chaos and explain some terms. These terms are used as conditions when making a home offer that, as a new buyer, you likely don’t know. Even if you have heard the term, you may not understand what it actually entails, so let’s get into it.

Appraisal

This is a term you’ve probably heard before, but may not fully understand. In general, an Appraisal is the value of something, such as a house, that has been assessed and determined by an expert. If you happen to be among the 30% who were able to buy a home in cash, this doesn’t apply to you but, if you are in the majority and purchasing with a mortgage, or you intend to refinance later, this matters. Your lender will generally require an appraisal, although some can waive this requirement depending on the size of your down payment.

The way it works is that your lender will find a qualified appraiser which is someone either licensed or certified to appraise, has knowledge of the area you are purchasing in, and must be impartial. Therefore, the individual must not have any financial interest, directly or indirectly, from the sale to be in accordance with federal law. Once the qualified appraiser is found, they will review the house itself based on the number of bedrooms and bathrooms, square footage, and other amenities both inside and out. After that, they will look at comparables (“comps” for short). These are homes sold in the last 6 months, within one mile of the appraised home, and have similar or comparable amenities. Generally, the appraiser will review three or four comps, but this all depends on the appraiser.

How does this affect your offer? 

The lender will only loan you the funds up to the amount that your home is appraised. Thanks to sites like Zillow and Redfin, you can look at houses that have sold recently and try to find your own comps to and estimate the value an appraiser might determine for the house. Then you can consider what you’re willing to offer to how much you can afford in a loan. If the appraised value and your offer differ, then you have an appraisal gap, which we’ll explain now.

Appraisal Gap

The Appraisal Gap is the difference between the appraised value and your offer for the home.

Appraised Value - Offer Value = Appraisal Gap

If the appraisal gap is positive, meaning the home appraised for more than you were willing to pay, that’s great. Your lender can now give you a mortgage for only the amount you wanted to offer or you can even increase your mortgage total and use the extra funds to renovate the home. For an example, you offer $300K and the home appraised for $315K. That leaves you with a $15K surplus you can use to make repairs or renovate the home.

$315K - $300K = $15K

Now, if the appraisal gap is negative, meaning your home is appraised for less than what you offered, the lender will only give you the appraisal amount. So, using the same example, if the appraisal comes in at $285K, you’ll end up with a negative $15K appraisal gap and the lender will only provide a loan for that $280K amount.

$285K - $300K = -$15K

How does this affect your offer? 

In a Buyer’s Market, or market where there are more sellers than buyers, you can come in with a lower offer (positive gap) and, if you get accepted, you have more financing to possibly renovate with. If you end up with a negative gap, that can be good because it may allow you to negotiate your offer down. Since there are more sellers than buyers, your sellers have more incentive to keep you and might be willing to come down on their offer.

In a Seller’s Market, or a market where there are more buyers than sellers (what we’ve seen recently), it will be unlikely you can low-ball your offer and get accepted. Also, since the bank will only finance the amount at which your home appraises, some sellers may not want to consider financing offers, even high offers, out of fear the house will not appraise and the buyer has to back out. One thing you can do to make your offer more appealing is to offer to cover an appraisal gap. Essentially, by including a clause in your offer that you can and are willing to cover a specific amount in cash in the case of an appraisal gap, you show the sellers that a gap won’t be a problem. The amount will be purely dependent on your situation, but it gives the sellers more peace of mind if they choose to accept your offer. It also protects you in the case the appraisal gap is larger than what you can afford and gives you room to back out while keeping your Earnest Money, which is our next term.

Earnest Money

Earnest Money (sometimes called a Binder) is a specific amount of money that a buyer is going to pay upfront when making an offer on a house. This is essentially a “good faith” deposit and is used to represent how serious you are with intending to buy a home. Generally, the standard for Earnest Money is about 1% to 3% of purchase price depending on where you live. Be aware, Earnest Money is a deposit and not extra money on top of your offer. To clarify;

Your Offer is $300K

Earnest Money would be $300k x 1% = $3K

Remaining at Close is $300K - $3K = $297K

The way it works is, once your offer is accepted, you’ll pay the Earnest Money to the title company who will hold it in Escrow, a third party account used to control payments for the two separate parties (Buyers and Sellers) making a transaction. This is usually due within about 3 days of your offer being accepted. This deposit will then remain in escrow until you either close on the house or one party backs out. If the sellers back out, you as the buyer will get your deposit back. However, if you as the buyer choose to back out, unless it’s for a reason protected under your offer contract (i.e. an extreme appraisal gap), the seller can keep the Earnest Money. Every situation is different and you may be able to back out without losing your Earnest Money, but you always run the risk of losing it in the case you choose to back out on an offer.

How does this affect your offer? 

Since the standard is 1% to 3%, one thing you can do to make your offer stand out is by offering a higher value for Earnest Money than your local standard. Your real estate agent should be able to help you determine how much is normal and how much can help you stand out, based on the market at your time of purchase. Since this is a deposit you must have the money upfront and be able to pay it within 3 days of being accepted. So, if you offer a $10K Binder, you better have $10K sitting in the bank when you make your offer. Just remember, your Earnest Money is essentially just paying a portion of your offer upfront, but you still stand a risk of losing it should you choose to back out.

Escalatory Addendum

Especially in today’s market, many sellers have been asking for “highest and best offers” sometimes within three days of listing the house for sale. They want to know how much you’re willing to pay for a house right away. Now, you may think the home is only worth a certain amount, but you really love this house and are willing to pay more to beat out other competitive buyers, you can do what’s called an Escalatory Addendum. An Escalatory Addendum is a clause stating that you’re willing to pay a certain amount over any offer up to a certain amount. So, to break that down, let’s say you want to buy a house for $300K but you know the market is competitive and the sellers want “highest and best” by the end of the day. You’ve already been pre-approved for a loan for $350K. What you can do is;

Offer $300K as Purchase Price

Escalatory of $1K Over Competitive Offer

Up to Max Price of $350K

So, the way that would work is, if someone offered more than you, the sellers could choose to go with your offer instead and you would have to pay the amount you offered in the Escalatory over the competitive offer. So, if the competitive offer is $325K;

$325K + $1K = $326K = Your New Offer

The other thing with an Escalatory Addendum, if a competitive offer comes in that you would be able beat with this clause, the sellers must provide you with the other offer so you can verify it. They can’t just tell you there was another offer and ask you to come in at a higher price.

How does this affect your offer?

Although this would be a bad idea in a Buyer’s Market, in extremely competitive markets like we’ve been seeing lately, an Escalatory Addendum gives you a lot of leeway in an offer while remaining in contention. It lets you state how much you want to pay while preventing you from being beat out by slightly higher offers. So, if the Sellers are just looking for the highest offer they can get, you could win out. However, remember that this doesn’t guarantee they will accept. Sellers may take any offer, even lower ones, for countless different reasons. An Escalatory Addendum isn’t a guarantee you will be accepted but it does make your offer more appealing and helps show how serious you are in buying a home.

Closing Cost

Another term you have likely heard before but may not fully understand, Closing Cost is the total value of additional costs incurred when conducting a real estate transaction beyond the purchase price of the home. These can include loan fees such as originator or underwriting, appraisal and inspection fees, real estate agent commissions, title searches and insurance, survey, taxes, deed recordings, and credit report charges. Beyond these fees, you will usually have to pay some premiums up front as well. Some big ones are two to three months of property taxes, first year’s homeowners insurance premium, and a portion of private mortgage insurance or upfront mortgage insurance premium. For the last one, this is dependent on the type of loan you are taking and the requirements for that loan. If you’re unsure what will be required, be sure to speak with your lender or mortgage broker to clarify prior to accepting a loan offer.

Since these fees are additional expenses, you will need to have the funds for this in your bank account prior to closing on top of your down-payment. You can always reduce your down-payment to cover these costs but, depending on your loan type, this may add some additional costs, such as PMI or higher VA Funding Fees, later down the line. Some of these fees (like a VA Funding Fee) can be rolled into your mortgage, but most will not and you should be preparing for how you will pay them before making an offer. Every transaction will be different, but it’s safe to assume about 3% of purchase price for closing costs. If you want to be on the safe side, it’s always smart to assume it will cost more. No matter what, closing costs must be disclosed to buyers and sellers before transaction can be completed to be in accordance by law. If you don’t understand your closing costs, discuss them with your lender or mortgage broker before signing anything.

How does this affect your offer?

If you assume 3% of purchase price, you can determine how much closing cost you think you can afford and use that to structure your offer. You don’t want to have an offer accepted only to realize at closing that you can’t cover the closing cost AND keep your monthly mortgage payments at a reasonable level. Also remember that closing cost can be negotiated. In a favorable market, you may be able to make higher offers that include clauses asking the seller to pay a portion of closing cost they normally wouldn’t. This will leave you more for a down-payment and can help keep your monthly payments lower. However, in a low inventory seller’s market like we’ve seen recently, this probably won’t be an option. Discuss your intentions with your real estate agent and they can help you determine what offer will make sense for prevailing markets. In that case, you can also negotiate with the lender to reduce or remove certain fees that appear unnecessary. If you think your closing costs don’t make sense, consider contacting an attorney who can review the terms to ensure the lender isn’t taking advantage.

The Wrap-Up

The terms we went through above can all be extremely helpful when making your offer. Taking them into consideration while adjusting for the market allow you to better structure an offer that can help you stay competitive without over paying. Just remember;

• The Lender will ONLY provide the funds up to the value the house appraises. If you plan to offer above what you think it will appraise, be prepared for that.

• If there is a negative Appraisal Gap, you can either cover the cost in cash or you can negotiate, depending on the market. Adding a clause that you will cover a certain value for Appraisal Gap can make your offer more appealing to Sellers.

• Earnest Money is a deposit and will go towards your purchase price when you close. However, if you choose to back out, you risk losing that amount. The higher your Earnest Money, the more serious you appear.

• An Escalatory Addendum is a great way to offer more without offering more. It gives you leeway to remain competitive without overpaying or being beat by slightly higher offers. An Escalatory Addendum is not a guarantee though.

• Closing Costs are generally about 3% of Purchase Price. Be prepared to pay that in cash at closing, although some fees are negotiable in favorable markets.

• Contact a Real Estate Agent in your local area. A good agent you can trust will make the whole process 100 times smoother

Understanding these terms can make a huge difference in how you structure your offer. The information above can help you get started but there is a lot more information out there. Speaking with qualified and knowledgeable real estate agents and experts is the best way to ask questions about what you don’t understand, clarify differences for different regions, and further understand the process for your local area. At least now you have a starting point to figure out what you else you want to know. As always, keep learning and seeking further education resources. Financial Literacy is the number 1 key to Financial Success!

*Disclosure* This is NOT financial advice and I am NOT a Certified Financial Planner. All information is provided for educational purposes only and is not to be construed as advice. Everyone’s financial situation is different and requires individualized planning. Seek out a Certified Financial Planner for assistance with your own financial situation.