When it comes to real estate and buying a home, there are many factors that need to be taken into account. One of the most important is understanding what an appraisal gap is and how it can affect your purchase.
Understanding the appraisal gap is especially important if you are a first time home buyer.
An appraisal gap can lead to complications when trying to close on a home and requires careful consideration before making any offers.
We want to make sure buying real estate is easy for you.
Therefore, in this article we will discuss what an appraisal gap is, how you can protect yourself with an appraisal gap clause or guarantee, other ways to handle an appraisal gap, and the difference between appraisal contingency vs appraisal gap coverage.
What Does Appraisal Gap Mean ?
An appraisal gap is the difference between the agreed-upon purchase price of a home and its appraised value. The result means that based on your contract price, your down payment is going to be to small.
Another way of saying this, you received a low appraisal value relative to your purchase price.
When a homebuyer makes an offer on a property, it is often based on their own research, such as comparative market analysis (CMA) of similar homes in the area.
However, when the property is appraised by a licensed appraiser, they may determine that the fair market value (FMV) is lower than what was offered by the buyer.
The difference between these two values is called an appraisal gap.
For example, lets say a home buyer agreed upon a purchase price or contract price of $400,000 and the appraised value is $380,000 they’d have a $20,000 appraisal gap.
One of the major reason why home purchases fail is an appraisal gap. This is why you need to asses the market before and use something such as Neo Home Loans competitive market analysis before you start your home search.
Why Do I Need An Appraisal When Buying A House?
Lenders will usually require an appraisal before providing a loan since it provides them with an independent assessment of a property’s worth.
Lenders require this so they can properly analyze the risk they are taking as well as meeting Federal and State regulatory requirements.
Why Does An Appraisal Gap Occur?
An appraisal gap can occur in two distinct markets: a rapidly increasing housing market or a quickly declining one.
Rapidly Increasing Market (A Seller’s Market)
In the case of rapid price increases or a seller’s market (when home buyers outnumber sellers by a wide margin and there are bidding wars), comparable sells that appraisers use when determining the appraised value don’t keep up with the changing market. Therefore, the comps used for appraisals will not accurately reflect the current market value of the property.
Rapidly Decreasing Market (A Buyer’s Market)
When housing prices are on a downward trajectory, home sellers may overestimate their property’s worth and buyers might be willing to pay too much. In short, buyers and sellers have anchoring bias.
Anchoring bias occurs when we have a purchase price in our heads and we don’t change it or don’t change it enough.
Other Factors
Other factors such as regional pricing differences, unique features of each property, and external economic pressures can also contribute to appraisal gaps.
For example, if there is an influx of people moving into a region due to job opportunities or other external circumstances, it could drive up demand for housing and consequently its price.
This can create an appraisal gap if appraisers are unable to properly account for these outside pressures in their estimations.
Furthermore, certain features like an updated kitchen or bathroom may add more value than expected and make it difficult for appraisers to accurately estimate its worth relative to similar properties with fewer amenities.
How Does An Appraisal Gap Clause Work In Real Estate?
An appraisal gap clause is a contract provision that protects a buyer in the event the property appraises for less than the agreed-upon purchase price.
It states that if the appraisal comes back lower than the purchase price, then the buyer is willing to cover up to a certain percentage of the difference.
For example, if a buyer agrees to buy a property at $400,000 and it appraises for $380,000 – $20,000 below the agreed price – with an appraisal gap clause in place, the buyer would be responsible for covering up to 5% of this difference (or $1,000).
This gives buyers protection against overpaying for properties and gives sellers assurance that their offers will still stand in case of an unexpected low appraisal.
The amount of coverage offered by an appraisal gap clause can vary from contract to contract. Typically buyers will agree to cover anywhere from 3% – 5% of any gaps between the agreed-upon price and appraised value.
In addition, to offering more financial security for both parties, having an appraisal gap clause in place also helps speed up deals as it eliminates much of the back-and-forth negotiations when trying to close on a home.
Ways To Handle An Appraisal Gap
Thankfully, there are several options for buyers to consider when dealing with an appraisal gap. You should discuss these options with your real estate agent prior to putting an offer on a house and entering a purchase contract.
Cash/Increasing Your Down Payment
The first option is to pay the difference. In essence, you would be increasing your down payment.
For example, if the appraisal gap is $20,000 increase how much cash you are giving to the seller by $20,000.
Needing to pay the difference is what you’ll most likely need to do in a seller’s market (i.e. when home purchase prices are increasing quickly). I’ve seen some buyer’s not willing to do this and they end up losing their earnest money!
Lower Purchase Price
The second solution to an appraisal gap is to negotiate a lower purchase price. This means that both parties agree on a reduced purchase price which brings them closer in line with what the appraised value of the property is.
This would most likely be used when its a buyer’s market (i.e. home purchase prices are decreasing quickly.
This is even more likely if the seller needs to sell ASAP. For example, many seller’s may have another home they purchased under contract with a contingency to sell their previous home. If that is the case, they need to sell ASAP.
Get A Different Appraisal
If you do not agree with the appraisal value, another option available to buyers is to get a different appraiser if their lender allows it. Sometimes this works because different appraisers may have more knowledge about certain areas and be able to provide more accurate values based on that.
Dispute The Appraisal
Your mortgage lender may not allow you to use a different appraiser.
However, you may dispute the appraisal value. If you are going to dispute the appraised value, you’ll want to have your real estate agent pull comps and come up with a really good reason why the appraised value is wrong.
Seller Held Financing
One rising method of acquiring real estate in general is seller held financing. This mostly occurs when the home buyers do not have enough money for a down payment.
In regards to appraisal gaps, a seller may be willing to hold a second mortgage loan. Therefore, you do not have to increase your down payment.
However, this method doesn’t always work and will depend on what type of loan you are using such as a conventional loan vs FHA loan.
Appraisal Contingency vs. Appraisal Gap Coverage
Appraisal contingency and appraisal gap coverage are both meant to protect buyers in a real estate purchase agreement.
Appraisal contingency is typically included as part of a standard purchase contract and provides the buyer with the right to reject the contract if the appraised value of the home comes back lower than the agreed-upon purchase price.
In this case, the buyer would not be obligated to proceed with the purchase, and their deposit would be returned.
On the other hand, appraisal gap coverage is language in the purchase contract that binds you to buying the house. You can ask for it to be removed or specify a cap on how much you’re wiling to pay to cover an appraisal gap.
This coverage generally applies when there is no appraisal contingency specified in the contract, so it ensures that even if there is a discrepancy between appraised value and purchase price, buyers are still able to proceed with their purchase without being out of pocket for any difference.
Is An Appraisal Gap Clause and/or Appraisal Gap Coverage Necessary?
Short answer in my opinion… Yes! You should never have to pay the difference that arises with an appraisal gap. At a minimum, the seller should pay the difference with you, i.e. share in the burden.
I’ve never bought a house and would never buy one without appraisal gap coverage or an appraisal gap clauses in the purchase contract.
However, you should do you homework prior to buying a home. Mortgage lenders and your real estate agent should be able to inform you on items such as an appropriate asking price, actual market value expectations or what fair market will be, and what your down payment should be.
Conclusion
Appraisal gap clauses are a great way to protect buyers and sellers from unforeseen circumstances when buying or selling a home.
By offering an appraisal gap coverage policy, buyers can be sure that any loss incurred due to discrepancies between apprised value and purchase price will be covered.
This ensures the buyer is able to proceed with their purchase without being out of pocket for any difference.
It’s important for both parties involved in a real estate transaction to understand all aspects of the agreement, including appraisal contingencies and appraisal gap guarantees, so they know what rights they have if there is ever an unexpected low appraisal.
