While mortgage interest rates are high and fewer people are making home purchases, it can still make financial sense to buy instead of rent.
Whenever you buy a property and intend to take out a mortgage on it, whether it be a house, condo or cooperative, all mortgage lenders will require an appraisal, which is an unbiased estimate of the true or fair market value of the property. All lenders order an appraisal during the mortgage loan process so that there is an objective way to assess the home’s market value, and ensure the amount of money requested by the borrower is appropriate.
However, getting a mortgage, or accepting an offer that is contingent on financing (many offers are), complicates a purchase transaction. It can potentially place both the buyer and seller in a unique circumstance: an appraisal gap. Many buyers and sellers are blissfully unaware of what an appraisal gap is and the possible complications, and delays, it can cause for a contingent sales transaction.
[Read: The Guide to Escalation Clauses in Real Estate.]
What Is Appraised Value and Why Are Appraisal Gaps Becoming More Common?
A property’s appraised value is based on historical comparable sales and other quantifiable factors, like its size and condition.
While housing market predictions eventually foresee a more buyer-friendly 2023 , certain housing markets remain incredibly competitive and rife with bidding wars. In this type of seller’s market — where homeowners are receiving multiple offers over the asking price — a property’s contract price will often be higher than its appraised value.
How an Appraisal Gap Works
So how does an appraisal gap work? Let’s do the math.
Theoretically, if you were buying a home for $100,000, and the deal was contingent on you getting a mortgage for 80% of the price, you’d need to put down $20,000 and take out a mortgage for $80,000.
But if the home’s appraised value ends up being lower — at, say, $80,000 — then the bank will only give you 80% of that appraised value, which is just $64,000. That means you’d need to come up with an additional $16,000 to close the deal.
If your offer is all cash, you don’t need an appraisal. If your purchase is not contingent on financing, but you are planning to finance some of it, you will still need an appraisal. In this case, though, the appraised value has little relevance to the deal as you, the buyer, must come up with the differential money regardless. However, in the more common “contingent on financing” purchase, both buyers and sellers need to pay close attention to how a potential appraisal gap will be addressed in the contract of sale.
[Read: The Guide to Earnest Money.]
How to Handle an Appraisal Gap
If you are a buyer with an offer contingent on financing and find yourself faced with an appraisal gap, you have a few options:
1. Pay the difference in cash between the appraised value and your offer (an additional $16,000 in the example above).
2. Try and renegotiate a lower price with the seller to shorten or eliminate the appraisal gap.
3. Walk away from the deal, as this situation is exactly what an appraisal contingency clause is for.
If you still want the home, but don’t have the liquid funds and the seller won’t budge, you can request a review of the appraisal. Alternatively, you can request a second appraisal with a new appraiser from the same bank, or apply with a different lender, as there is a chance that another appraiser will value the property higher.
While these two options can preserve the deal, they will also delay the transaction process. This could be impractical in a hot market when there are multiple offers on the table, and an impatient seller can easily pivot to the next buyer.
Typically, a purchase contract has an appraisal contingency, which is wording that says the buyer can call off the deal if a property appraises for lower than they offered. But in competitive markets, where buyers outnumber sellers, many buyers waive the appraisal contingency to sweeten their offer.
Appraisal Gap Coverage
There is one other interim legal step you can take as a buyer that could satisfy and lessen the risk for the seller, and also not leave you completely exposed to a large appraisal gap and unexpected expense: getting appraisal gap coverage.
Appraisal gap coverage is an insurance policy that is written into a contract, in which the buyers can stipulate that they will pay the potential difference between the appraised value and the contract price, up to a certain amount. From a seller’s point of view, this lowers the risk of a financing-contingent deal falling through. It guarantees an acceptable appraisal gap amount that can occur without giving the buyers a way out of the deal.
From the buyers’ point of view, it makes their offer more compelling, but also allows them to walk away if the appraisal gap is bigger than the agreed-upon amount, or what they can afford, which is clearly outlined in the contract.
[Read: How to Save Enough for a Down Payment.]
While the math here is simple, many buyers and sellers forget how important it is to consider the potential impact of appraisal contingency clauses, appraisal gaps and including an appraisal gap coverage clause in their contracts, especially in a hot market. The topic can perplex even the savviest buyers and sellers, so make sure to discuss all of your options with your real estate agent, lender and real estate attorney before submitting or accepting an offer, and certainly before signing a contract.
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Everything You Need to Know About Appraisal Gaps originally appeared on usnews.com
Correction 01/06/23: This story was published at an earlier date and has been updated with new information.
