In one line: When the lender's appraisal comes in under the agreed price, and someone has to cover the difference.
A lender lends against the appraised value, not the contract price. When the appraisal comes in lower, the gap between the two is not financed: the buyer brings it in cash, the seller cuts the price, the two split it, or the appraisal contingency lets the buyer walk.
Gaps appear when a bidding war carries a price past the comps, and in a fast-rising market where closed sales trail asking prices. A buyer who waives the appraisal contingency to win an offer is agreeing to cover any gap in cash.
Kouzr's comps-based discount is the early warning: a home asking well over nearby homes of similar age and size is a home whose appraisal is likelier to disappoint.
A worked example
Contract at $520,000, appraisal at $500,000. At 20% down the lender lends 80% of $500,000, or $400,000, not $416,000. The $20,000 gap comes from the buyer's cash, a price cut, a split, or the appraisal contingency.
Questions people ask
What happens if the appraisal is lower than the offer?
The lender lends against the lower number. The buyer brings the difference in cash, the seller reduces the price, they split it, or, with an appraisal contingency in place, the buyer cancels with the earnest money returned.
Should I waive the appraisal contingency?
Only with the cash to cover a gap and a clear read on the comps. Waiving it wins bidding wars and is how buyers end up paying more than the home will support at resale.