What to Know Before Entering a Bidding War
Credit: Robert Fairchild
Despite warnings that the real estate market is overvalued, Canadians continue to take the leap into homeownership. With mortgage rates still historically low, certain parts of the country – namely Toronto, Vancouver and Calgary – have become hotbeds for bidding wars. Because bidding wars are becoming so increasingly common, we thought we’d do a little research on what you should know before you find yourself in one.
How a Bidding War Works
To understand how a bidding war works, let’s first look at how a regular home sale works. In a typical real estate transaction, a seller lists their home for sale at a specific price and you, the buyer, would view it then submit your Offer to Purchase. Your offer outlines the purchase price you’re willing to pay, and any conditions that need to be fulfilled, such as securing financing or passing a home inspection. Often, you’ll submit an offer below the seller’s asking price, which you may go back and forth on once or twice before the seller finally accepts.
In a bidding war situation, the dynamic is very different. In this case, the seller will often list the home below market value in order to tempt prospective buyers, and may not accept offers from interested homebuyers for several days. During that time, all interested homebuyers submit their bids. If you want to be competitive and make your offer more attractive than the rest, you may choose not to include some of the conditions mentioned above, like the successful completion of a home inspection. The seller will then review the bids, and typically the highest bid with the fewest conditions “wins”. It’s more or less like an auction system, and can result in some very high sale prices.
What Happens if Your Offer is Higher Than the Appraised Value
Before you can get a mortgage, your lender will send an independent home appraiser to view the home you want to buy and determine its value. But what happens if the appraised value ends up being lower than the price you offered? Let’s take a look.
Let’s say that you win your home in a bidding war at a price of $800,000. You are planning to make a 20% down payment ($800,000 x 20% = $160,000), which means you’d need a mortgage of:
Purchase Price – Down Payment = Mortgage
$800,000 – $160,000 = $640,000
Unfortunately, the home’s appraised value is only $750,000 and the lender will only finance a home valued at that amount; this results in a $50,000 shortfall, because you have to pay the seller the full $800,000.
In this situation, you have a couple of options. First, you could borrow the $50,000 from a family member or friend.
Your other option is to make up the $50,000 shortfall yourself by taking that amount from your planned down payment. You could simply write the seller a cheque for $50,000 and only put down $110,000 ($160,000 – $50,000). In this case, you would have to pay a mortgage default insurance premium because you wouldn’t have the full 20% down payment, but at least you’d still be able to secure a mortgage and buy the home.
Entering a Bidding War with Only 5% Down
The situation outlined above is not ideal but, as you can see, it can be resolved one of two ways without losing the home. Where real problems arise is when the same bidding war situation above occurs but you only have a 5% down payment.
In this situation, you can’t take money from your down payment because it’s already as small as it can be (the minimum down payment in Canada is 5% of the home’s purchase price). In this case, you have no choice but to borrow money from family, a partner or friends.
If borrowing money isn’t an option for you, then it’s likely you won’t be able to secure the financing needed to purchase the home. This becomes a serious problem if you waived the financing condition in your offer. In waiving the financing condition, you committed to being able to pay the seller your offer price – and there’s no way to back out of the purchase without penalty. By backing out, the seller has the right to keep the deposit you submitted with your offer, and if they have trouble selling their home, they can even sue you for the value of it.
So what’s the moral of this story? “You can’t participate in a bidding war if you are only putting 5% down, that’s the reality of the situation,” says Toronto mortgage broker James Laird. He strongly advises clients to never enter a bidding war unless they have a sizeable down payment.
Before jumping into any part of the journey towards homeownership, we suggest you find a realtor you feel comfortable working with, as well as a mortgage broker who can help you with the financing of your future mortgage. Good luck out there!