What is an Appraisal Gap?
When you put an offer on a home and intend to mortgage it, no matter what type of property, all mortgage lenders will require an appraisal. An appraisal is an unbiased estimate of the true fair market value of the property. This is usually assessed by a professional appraiser approved to assess the property by the bank. All lenders order an appraisal during the mortgage approval process so that they have an objective way of assessing the home’s market value to make sure the amount of money a borrower is asking for is appropriate for the property.
But having an appraisal performed on a property can complicate a purchase transaction in such a hot seller’s market where several buyers are competing for the same property and some are waiving appraisals. When bidding wars drive the price up it can potentially place both the buyer and the seller in the unique circumstance of an appraisal gap.
What is appraised value? Why are appraisal gaps so common right now?
A property’s final appraised value is based on several factors, some of the main factors include comparable sales in the area and other factors such as the size and the condition of the home.
Right now, with such a limited number of homes for sale and a very high number of buyers hoping to find a home and take advantage of a mortgage at a very low-interest rate, some buyers will compete with one another and offer to pay a higher price in hopes of having their offer accepted over other competing offers. It is not uncommon for home sellers to be offered more than the list price. In many cases, this results in the offer or contract price being higher than the appraised value of the home. This is an appraisal gap.
How does the mortgage math work with an appraisal gap?
If you agree with your lender to pay 20% down on the purchase price of your home and you, for example, were buying a $100,000 home, then the bank would be agreeing to pay 80% of the price, or $80,000, and you will be expected to pay $20,000.
If after the appraisal the home is only actually found to be valued at $80,000 then the bank will only agree to give you 80% of this true appraised value for the home which would be $64,000. So, if you offered to pay $100,000 for the home, you would then need to find a way to come up with an additional $16,000 to close the deal, or come back to the negotiation table with the seller as long as you have included an appraisal contingency within your offer.
Buyers with an appraisal contingency in their offer have a few options: to pay the difference between the appraised value and the offer, or to renegotiate a lower price with the seller after showing that the property came in appraised at a lower value. The appraisal contingency also does allow a buyer to walk away from a deal when an appraisal comes in lower than the agreed-upon purchase price.
If you have your heart set on the home but the seller refuses to negotiate a different price you can request a review of the appraisal or a second appraisal with a new appraiser ordered from the same lender. You could also try to apply with a different lender and see if their appointed appraiser will value the property higher.
Appraisal Gap Coverage
There is another option you can take as a buyer that could help to lower the risk for the seller and not leave you as the buyer completely hung out to dry should an appraisal gap be found. This option is to get appraisal gap coverage.
This is an insurance policy written into a purchase contract where the buyer can stipulate that they will pay any potential appraisal gap difference between the actual appraised value and the offer up to a certain amount. To a seller, this helps lower the risk of a deal that is contingent on mortgage approval not going through. It can help to guarantee that the buyer will still purchase a home should there be an appraisal gap which is becoming more and more likely with offers over list price. It makes a buyer’s offer more appealing while still giving them the security of being able to walk away if an appraisal gap is larger than the agreed-upon gap amount.
No matter what you decide when it comes to appraisal gaps, it is always a smart idea to talk your offer over with an experienced real estate professional, either an agent or an attorney, before submitting an offer. They can help you to determine the most accurate assessment of what the fair market value of a home most likely is, and if making a higher offer is really in your best interest as a buyer.