Appraisal gaps in today’s market
Rapidly rising home prices have led to an increasingly common challenge for home buyers and sellers: the appraisal gap.
When a home’s appraised value comes in lower than the contracted purchase price, buyers must either cover the difference, renegotiate, or walk away.
Luckily, there’s a multitude of ways to deal with an appraisal gap. Buyers should work closely with their agent or Realtor to structure their offer in a way that protects against appraisal gaps — and have a contingency plan in case one happens.
In this article (Skip to…)
What does an appraisal gap mean?
An appraisal gap happens when the appraised value of a home for sale comes in lower than the contracted purchase price agreed upon by the buyer and seller.
Appraisal gaps are common in a hot real estate market. When the number of homebuyers surpasses the inventory of homes available on the market, home prices rise swiftly.
As home prices increase at a faster pace than recent sales for comparable homes, appraised values struggle to keep up. And, as buyers bid over the asking price to win those homes, appraisal gaps can easily happen.
Appraisal gap example
For example, let’s say the list price on a home you’re eyeing is $300,000. To make your offer more attractive, you submit an offer for $325,000 with a down payment of 5%.
The seller accepts your offer, but the appraisal comes back at just $305,000. Unless the seller agrees to lower the price, you’ll need to come up with additional funds.
- Purchase price: $325,000; 5% down payment = $16,250
- Appraised value: $305,000; 5% down payment = $15,250
- Difference between purchase price and appraisal: $20,000
- Total cash needed (down payment + appraisal gap): $35,250
You don’t always need to cover the full appraisal gap in cash, though.
Jon Meyer, licensed MLO and The Mortgage Reports loan expert, explains that “covering the difference out of pocket is only needed when you’re making the minimum down payment allowed by your loan program.”
If you’re making a 10% down payment, for example, but your loan program allows as little as 3% down, you could take some of that cash you’d saved for the down payment and put it toward the appraisal gap. You’d end up with a bigger mortgage loan, but it could help you secure the home you want.
What is an appraisal gap clause?
An appraisal gap clause can be written into the purchase agreement to help safeguard against a low appraisal. The clause states that the buyer will cover the difference between the appraised value of the home and the purchase price, up to a certain amount.
Here’s an example of an appraisal gap clause:
“Buyer and seller agree that if the appraised value comes back lower than the purchase price, buyer agrees to pay up to $20,000 above appraised value, but not exceeding the purchase price.“
Appraisal gap clauses can help strengthen your offer in a bidding war. It gives the seller an extra level of confidence that the deal won’t fall through because of a low appraisal. And it can protect you, the buyer, from having to renegotiate the purchase price or lose out to another bidder.
Why appraisals are necessary in real estate
Unless you’re paying cash for your new home, your lender will require an appraisal.
Home appraisals are one of the most important safeguards for the buyer and the lender. Using a systematic valuation process, appraisers keep both parties from overpaying.
For home buyers, an appraisal determines the value of the home you’re purchasing. This protects you financially, especially if there’s a substantial difference between what the home is worth and what you agreed to pay.
For lenders, an appraisal confirms that the sales price is properly aligned with your home’s value based on condition, features, and location. The appraisal also lets your lender know that your home can be sold to cover losses in the event your mortgage goes into default.
My home appraised too low. What do I do now?
A seller’s market happens when the demand for homes is higher than the supply on the market. The resulting bugging wars can cause home values to rise at a rapid pace. When this happens, appraisers often struggle to determine the actual market value, resulting in low appraised values.
But what exactly does it mean for you as a buyer when the appraisal comes in lower than the purchase price?
As a buyer, you may need to put more money down. This is because your lender will calculate the loan-to-value ratio (LTV) based on the appraisal value, not the purchase price.
But you won’t always have to pay the full gap out of pocket.
5 Ways to handle an appraisal gap
As a buyer, there are a few routes you can take when an appraisal gap occurs.
1. Decrease your down payment percentage
One option for the buyer is to reduce their down payment percentage and use the extra cash to cover the appraisal gap.
For instance, say you planned to put 20% down on a $400,000 offer. That’s $80,000 out of pocket. But the appraised value comes in at only $380,000. Well, instead of using the full $80,000 as a down payment, you could use $20,000 of that money to cover the appraisal gap in cash. This leaves you with a $60,000 (15%) down payment on your loan.
The downside of this strategy is that if you reduce your down payment to below 20%, you’ll have to pay for mortgage insurance — at least temporarily. But remember that PMI can be canceled once you reach 20% home equity. And if it can help you secure a home in this red-hot market, temporary PMI may be well worth the cost.
“This tends to be the most common option,” says Meyer.
2. Pay the difference in full
Regardless of the appraised value, as the buyer, you can simply pay the difference between the contract price and the appraised value. If an appraisal shortage is significant, however, buyers may not be able to cover the full amount.
3. Renegotiate terms with the seller
The buyer and seller can essentially start over with negotiations now that the appraised value has been determined. In a buyer’s market, the seller might agree to lower the price to match the appraised value. In a seller’s market, however, the homeowner is more likely to go with a buyer who has additional cash and can cover the difference out of pocket.
4. Include an appraisal gap clause
As described above, an appraisal gap clause can protect the buyer and seller from having to renegotiate their purchase agreement when an appraisal comes in too low. We explain how that works in more detail below.
5. Terminate the contract
Assuming you are still within your appraisal contingency period, you can simply walk away from the deal. This is likely the least attractive option, but it may be the only one if you aren’t able to cover the appraisal gap using one of the strategies below.
How buyers and sellers benefit from an appraisal gap clause
If a buyer doesn’t have the means to make up the difference between the contract price and the appraised value, that highest offer that was accepted by the seller is now rendered virtually useless.
As a result, if a buyer wants their offer considered, high offers alone are no longer enough.
This is when an appraisal gap clause can be invaluable. It can be used to reduce or eliminate the risk of the seller losing time and money due to a low appraisal.
For a buyer’s offer to even be considered, many sellers expect to see an appraisal gap clause as part of their contract offer. The clause states that they agree to cover an appraisal gap up to an agreed-upon amount.
“Not only does an appraisal gap clause make it more likely your offer will be considered, but it’s also really the only way to compete in this market.”
–Allison Barnett, EXP Realty
According to Allison Barnett at EXP Realty in Marietta, GA “Appraisal gap clauses written into offers have become routine. Not only does an appraisal gap clause make it more likely your offer will be considered, but it’s also really the only way to compete in this market.”
More than ever before, having a good Realtor is imperative for buyers in this market, says Barnett. “Not only can a Realtor can help structure a deal so that the buyer’s offer is in the running, but they can also ensure the buyer isn’t overpaying.”
Barnett goes on to say, “What’s equally important, though, is how an appraisal gap clause protects buyers. Not having something in writing that explicitly states what the buyer will cover in the event of a low appraisal can mean wasted time and money on home inspections and home appraisals when a contract falls through.”
Appraisal gaps: The bottom line
As bidding wars become the norm, selling prices continue to get driven well above market value.
To sellers, rising home prices sounds like great news. But this isn’t the case unless the buyer can cover the difference in the event of a low appraisal.
For buyers, inflated home prices that result in low appraised values may mean you may have to pull the plug on a deal and start over.
An appraisal gap clause not only gives the seller a guarantee the deal won’t fall through due to a low appraisal, but it also saves you from having to back out of the deal or cover the entire difference.
Appraisal gap clauses can be the key to making (and winning) a competitive offer in a hot real estate market.
The information contained on The Mortgage Reports website is for informational purposes only and is not an advertisement for products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policy or position of Full Beaker, its officers, parent, or affiliates.