What Is an Appraisal Gap? Tips and FAQs for Home Buyers
For home buyers, appraisal gaps can confirm that you’re getting a good deal on a home, or they can be an unwelcome and expensive headache. Since they come toward the end of the home buying process, appraisal gaps are one of the final hurdles between you and your dream home.
But what if the appraisal claims the house is worth less than your agreed-upon purchase price? This may force you to spend even more upfront for the home and can even make you question whether you buy the house at all. Thankfully, there are plenty of options to protect yourself from this situation. Follow along below to find out how appraisal gaps work and how to avoid their negative ramifications.
How Do Appraisal Gaps Work?
An appraisal gap is the difference between the appraised value of the property and the purchase price. These gaps arise due to one of the last and most important steps of the home buying process: the home appraisal. A home appraisal is when an independent appraiser analyzes a home and compares it to similar homes in the area to determine its fair market value. The appraisal occurs after you put in an offer on the home, so you already know the purchase price at the time of the appraisal.
If the home's appraised value is higher than the purchase price, that's great news for you as the buyer. You can still purchase the home for the agreed-upon purchase price and move into your new home with additional equity, knowing you got a good deal. If the appraised value is lower than the purchase price, there are some other roadblocks to buying the home. This can be stressful, but there are several ways to move forward with the purchase.
What If The Appraisal Is Lower Than The Purchase Price?
When the appraisal comes in low, the main issue is that your lender will not loan you more than a percentage of the appraised value. The exact percentage is determined by your loan type and lender, but most conventional loans allow you to borrow up to 95% of the value.
Let’s say you agreed to pay $450,000 for a home, but the house is only appraised at $430,000. If the seller won’t reduce the sale price, you’ll have to come up with the difference of $20,000 to buy the home. Here are some options if you run into this predicament.
- Make a larger down payment: You can increase the down payment to cover the amount of the appraisal gap. While this may be a significant increase in your upfront costs, it is the most straightforward solution to fix the issue on your own.
- Renegotiate with the seller: You don't have to cover the costs alone, especially if the current market favors buyers. You can ask the sellers to lower the purchase price to meet the appraised value or ask for other seller concessions to make up the gap.
- Request a new appraisal: You can dispute the appraisal and request a new one by submitting a reconsideration of value document in writing. Work with your agent to gather evidence, such as mistakes in the report or inadequate work by the appraiser, as to why the appraised value is incorrect.
Back Out Of The Contract
If none of the options above are possible, you can back out of the contract. This option could have legal and financial ramifications, so reading and understanding your contract before deciding is essential. One of the most common implications is losing your earnest money, the deposit you put into escrow when you signed the purchase agreement. However, depending on the details of your contract, you may have to pay much more or much less to back out of the contract.
Appraisal Guarantee Clause Vs. Contingency Vs. Gap Clause
Working with your real estate agent to ensure that one of the following clauses is in your contract could save you thousands of dollars.
Appraisal Guarantee Clause
An appraisal gap guarantee clause is a section of the contract that requires the buyer to pay the purchase price regardless of the home's appraised value. This isn't ideal for a home buyer, but it can be an enticing incentive for sellers to accept your offer over others. An appraisal gap guarantee may become necessary in a seller's market with maximum competition for every home. As a buyer, if you choose to include this, you may need to have access to additional funds in the event that you do have to pay the difference out of pocket.
An appraisal contingency favors the buyer by allowing them to back out of the contract if the appraisal comes in low. With this protection, you can back out of the contract and still keep your earnest money.
Appraisal Gap Coverage Clause
The appraisal gap coverage clause limits the difference between the appraised value and the purchase price. This can help you make a competitive offer while protecting you from paying more than you can afford.
This middle ground between an appraisal gap guarantee and a contingency can benefit buyers and sellers. Let's continue with the previous example in which you agreed to buy a home for $450,000 that is appraised at $430,000. If you included an appraisal gap clause in your contract that requires you to pay no more than $10,000 over the home's appraised value, you and the seller could split the appraisal gap.
Appraisal Gap FAQs
Here are some of the most common questions about appraisal gaps.
Why do I need appraisal gap coverage?
An appraisal gap coverage clause allows you to make an offer that will entice sellers but still protect you from overpaying for a home. In a fast-moving seller's market in which you may be competing with cash offers, appraisal gap coverage is an excellent middle ground to keep your offer competitive and protect you from ballooning prices.
How much appraisal gap coverage should I get?
Your appraisal gap clause will state a specific amount you’re willing to pay to cover the appraisal gap, so it is essential to have this amount available in cash when you close on the home. Talk with your real estate agent and analyze your financial situation to determine an amount you can afford that keeps your offer competitive.
Is appraisal gap financing available?
Appraisal gap financing is available, usually for low-income buyers or in low-cost real estate markets, to encourage investment in underserved communities. Banks, local governments or nonprofit organizations can provide financing to entice buyers to invest in a community or allow low-income buyers to buy a home they couldn't afford because of an appraisal gap.
The Bottom Line: Know Your Options If There’s An Appraisal Gap
An appraisal gap is the difference between a home's appraised value and its purchase price. Appraisal gaps do not usually affect the home buying process if the appraised value exceeds the purchase price. Still, they can cause issues if the appraisal comes in lower than the purchase price. Since the lender will only allow you to borrow up to the respective percentage of the appraised value for your specific loan product, you must find a way to pay for the gap.
There are several clauses that buyers can include in their contracts to address an appraisal gap, making their offer competitive while protecting themselves from overpaying for a home. If you are prepared for this possibility and ready to start the application process, you can see what rates you'd qualify for in today's real estate market.