What's an appraisal gap - and what can you do about it?

What's an appraisal gap - and what can you do about it?

Posted on Oct 27, 2022

What’s an appraisal gap? If you’re looking for homes, you may have come across this term - and you might wonder what it could mean for closing on your property.

The appraisal gap is the difference between what you offered to pay for the home, and what the independent appraiser determines the home is worth. 

How an appraisal works

So how does an appraiser determine what your home is worth? They consider current market trends, the home's features, what nearby, similar properties have sold for (comps), and more. The appraiser will conduct a home visit in addition to their research on the home and surrounding area. 

Based on these factors, an experienced Realtor can give you a good estimate of what the home should be worth - so most of the time, the results of the appraisal shouldn’t be too surprising.

The problem

When the home appraises for less than you offered, the lender won't approve the loan. If you were to default on your mortgage and enter foreclosure, the lender wants to know they can resell the home and make their money back. They've also approved you for a specific LTV (loan to value ratio) that may not hold up if you borrow a larger amount.

According to Fanny Mae, appraisals come in low less than 8% of the time, and come in high about 12% of the time (less of a problem for buyers). In a fast moving market, though, low appraisals become more common. In 2021, 23% of contracts were delayed due to low appraisal issues, according to the National Association of Realtors.

Most home buyers don’t want to overpay for a home, anyway. If the unexpected happens and you need to sell your home sooner than expected, you don't want to lose a ton of money unnecessarily. It's also easier to build equity in your home if you buy it at, rather than over, market value.

What’s an appraisal contingency?

An appraisal contingency, or an appraisal guarantee, allows the homebuyer to back out of the sale if the home appraises for less than the purchase price they agreed to. 

During the height of the seller’s market last year, many buyers opted to waive their appraisal contingency in order to make their offers more appealing to sellers. 

Dropping the contingency is only an option if you can cover the difference yourself with cash, which won’t be an option for all buyers. It’s also worth considering whether you really want to overpay for a home - it’s the sort of decision people often end up regretting if they feel they bought at the peak of the market. You might be better off finding a home that fits within your budget.

“The simplest way to add the appraisal contingency is to include an addendum with your offer that stipulates what sort of burden the buyers are willing to take. For example, they can send an offer saying, ‘We will contribute $5,000 in the event of a low appraisal towards a new sales price.' That way if the appraisal does come low, both parties know exactly what the buyers are committing to,” says Muoki Musau, a Virginia-based Realtor. “Alternatively, they could renegotiate a new sale price with the seller, where they bring a certain amount of additional funds towards a new price. Or they could simply settle for the appraised value if it's agreeable.”

When it comes to writing up the contract, Muoki advises specificity. 

“Have your numbers in mind from the beginning, so you're not surprised later. If $5,000 is the most you can do, or the most you're willing to do, put it up front in your offer. The fewer surprises, the better. For everyone,” he explains.

The solution

So what happens when an appraisal comes in too low? There are a few possible outcomes.

  • You can cancel the contract, using the appraisal contingency clause.
  • You can negotiate with the seller and get them to lower their offer price and/or offer to fund the gap with cash yourself - many will opt to meet in the middle, if possible.
  • You can contact the lender and request another appraisal and see if it comes in higher. "Additionally, you can provide your own CMA report to justify a re-inspection for a higher value," notes Muoki.

Appraisal gap example

Let’s say that you put in an offer for a $400,000 home, but the appraised price comes in lower.

  • Purchase price: $400,000; 10% down payment = $40,000
  • Appraised value: $380,000; 10% down payment = $38,000
  • Difference between purchase price and appraisal: $20,000
  • Total cash needed (down payment + appraisal gap): $58,000

It’s important to note, though, that you could pull some of the money out of your down payment and put it towards the purchase price. Covering the difference in cash is necessary only when you’re already paying the minimum down payment. Pulling money out of the down payment will mean your monthly mortgage payments go up, though, since you’re putting down less and borrowing more. 

So how do you negotiate an appraisal gap?

Your Realtor will do the heavy lifting for you when it comes to negotiating. What you can offer the seller will depend on your financial situation and what you’re comfortable with offering or giving up. If you have enough cash on hand, you can cover the gap yourself - it’s also fairly common for the seller and the buyer to split the difference between themselves.

You could also try to be more flexible in other ways (like making certain repairs or updates yourself, rather than having the seller do it as previously agreed to).

“Normally, it isn't difficult to negotiate if the agents have prepared their clients for that transaction checkpoint," says Muoki. "Challenges arise if the offer price is already below list price. If the appraised value is lower than that, sellers may feel unwilling to lose more money (or at least they think they're losing money). 

A year ago, negotiating the appraisal was simply, 'Pay the difference or we're going with another offer' because it was so competitive! But the situation is different now and there is more room for equitable exchanges in determining a new price. 

Other factors like the presence of appraisal gap funds from the buyer, the time the home has been on the market, and the presence of other offers all add context to the appraisal negotiations."

Can you finance an appraisal gap? 

You can’t get money from a lender to cover the appraisal gap - the lender that pays for your house isn’t going to let you borrow beyond what the home is worth, and you won’t be able to go to alternative financers because your lender will consider this as part of your debt-to-income ratio and it could impact your ability to qualify for the home. 

How do you avoid an appraisal gap?

The most important step for avoiding appraisal gaps is offering a fair price for the home based on market value. Regardless of what the home is listed at, your Realtor can help you determine what the appropriate market price is for the home based on recent comps of similar properties nearby, and an evaluation of how much value updates and renovations have added to the home. 

The more you offer beyond what seems to be the market rate for the home, the greater the likelihood that you’ll run into the appraisal gap. You can consider other ways to strengthen your offer beyond just trying to offer the most money (like offering a seller rent back agreement). 

For further reading

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