How Do Appraisal Gaps Work in Real Estate

What is an Appraisal GapPhoto byDeposit Photos

What is an Appraisal Gap, and How Do They Work?

There are many things that buyers need to research when buying a home. At the top of the list of importance is the correct amount to offer to pay for the home.

In real estate, there is not always an exact science to offering the right amount. Leaning on the assistance of a real estate agent can help, but even that is not foolproof.

When you are getting a mortgage to buy a home, the lender will have it appraised by an independent appraiser.

Sometimes the appraised value comes in lower than the purchase price. When the appraised value is lower than the contract price, it's called an appraisal gap. Appraisal gaps are more commonplace when bidding wars take place.

In strong seller's real estate markets, potential buyers are often okay with moving forward when there is an appraisal gap.

What is an Appraisal?

When home buyers are getting a loan from a mortgage lender, they will want to ensure there is ample equity in the home. Doing so protects their interests.

Lenders will hire an appraiser who will evaluate the current market value. They do this by comparing the property to other similar homes.

Occasionally, there can be a gap in the appraisal vs. the purchase price. When this happens, the buyer either has to increase their down payment to make up the difference, or the seller must reduce the contract price.

There is almost always an appraisal contingency in buyers or even balanced markets. The appraisal contingency states the home needs to appraise for the purchase price, or the buyer can get their earnest deposit money back.

What is an Appraisal Gap Coverage Clause?

When the real estate market favors sellers, there are often bidding wars. A bidding war between several buyers can drive the sale price tens of thousands of dollars over the asking price.

When this happens, the odds of an appraisal gap increase. One of the reasons sellers prefer receiving a cash offer is because they don't want to accept an offer only to find out their home didn't appraise.

They could lose the buyer and be back to square one. One way around this issue that has become popular over the last few years is an appraisal gap coverage clause.

An appraisal gap coverage clause guarantees buyers will move forward even if the appraisal is low.

What is an Appraisal Gap Guarantee?

The appraisal gap guarantee is language inserted into a purchase agreement that states a buyer will cover the difference in any potential appraisal gap.

For example, if a home is listed at $650,000 and a buyer bids $50,000 over asking, their purchase price would be $700,000.

If the buyer puts down ten percent, their mortgage would be $630,000. If the appraisal comes in at $675,000, there would be an appraisal gap of $25,000.

Essentially the appraiser has deemed the home's value to be worth $25,000 less than the agreed-upon purchase price.

The lender will only lend ninety percent of the appraised value or 90 percent of $675,000, which is $607,500.

For the transaction to proceed, a buyer must increase their down payment.

Without an appraisal gap guarantee from a buyer, the seller would be out of luck. The appraisal gap guarantee is the exact opposite of an appraisal contingency.

An Appraisal Gap Coverage Clause Can Be Limited

An appraisal gap clause is most potent when the buyer guarantees to cover any difference in the appraisal regardless of how much it is.

There is significant exposure for a buyer when there is no cap amount. To add protection, buyers could limit how much of an appraisal gap they are willing to cover.

For example, buyers could state they are willing to guarantee up to a $25,000 appraisal gap. In a bidding war, it could be a mistake not to guarantee the entire shortfall.

Summary of Appraisal Gaps

  • The appraisal gap is the disparity between an appraised value and the contracted price of a property for sale.
  • Some appraisal gaps can lead potential buyers to abandon the deal, whereas others are tolerable and will continue with the transaction by increasing their down payment amount.
  • In a seller's market with limited inventories of properties for sale, there are increased odds that an appraisal gap may occur.

Final Thoughts

When in a seller's market, it will often be wise to offer an appraisal gap guarantee to increase your chances of landing the home.

An appraisal contingency can ensure you don't overpay for the property if it's a buyer's market.

Understanding the local market conditions is always essential. Lean on the advice of a local real estate expert for help.

Did you enjoy this advice on an appraisal gap clause? See other real estate articles on News Break for more timely tips and advice. Bill often writes about general real estate, mortgages, finance, moving, and home improvement.

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Bill Gassett is an avid writer for numerous real estate topics including finance, mortgages, moving, home improvement, and general real estate. His work has been featured on numerous prestigious real estate publications.

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