What is an Appraisal Gap Clause?
How Does an Appraisal Gap Clause Work in Real Estate?
When you make an offer to the seller, and they accept, you still need the home to appraise when buying the home with a mortgage. Even when buying a home with cash the buyer may want to make sure the value meets or exceeds the offer amount. When buying a home with a mortgage most of the times an appraisal will be required as part of the process. If there is a difference between the amount offered and the appraised value, the purchase could fall through. An appraisal gap clause can prevent the transaction from falling through as this article explores. (Be sure to check out the video down below for more on the appraisal gap clause.)
What are Appraisal Gaps?
When the agreed purchase price of the home is higher than the appraised value, those in the real estate industry refer to it as an appraisal gap. The appraised value is determined by a licensed appraiser hired on behalf of the lender to ensure they aren’t lending more than the home is worth. For example where a contract to purchase a home is priced at $400,000 and the home actually appraises at $350,000 the lender will not allow the mortgage to be approved unless the purchase price is lowered to $350,000 or the buyer brings additional money to the closing table.
How much additional money the buyer must bring depends on the loan to value amount the buyer is borrowing based on. At an 80% loan to value (LTV) ratio the buyer must bring 20% of the total home value as cash to the closing table. Depending on the loan type some LTVs can be higher than 80%.
Closing the Gap
If you have to deal with an appraisal gap when buying a home, there are a few options to consider:
Covering the difference
You can pay the difference between the sales price and the appraisal value if you have the money available. Perhaps you have some investments you can raid if you don’t have the cash on hand. The lender may allow the buyer to take out another loan to help with bringing cash to the closing table. If borrowing additional money is needed to close on the purchase and the additional loan amount will impact the debt-to-income ratio requirement that strategy may not be allowed by the lender.
Depending on the LTV amount if the lender has programs where the buyer can bring less cash to closing, for example with a 90% or a 97% LTV loan the buyer can close the deal in that case but they may be overpaying on the house. Depending on the loan as well the buyer may face additiona monthly charges in the form of private mortgage insurance also known as PMI.
While the buyer might have already gone through many negotiations with the seller during the offer period and inspections, renegotiation is another option to deal with appraisal gaps. The buyer can ask the seller to reduce the purchase price to meet the appraised price in which case the lender will move forward. If the seller is not willing to reduce the price, the buyer could offer to bring more cash to the closing table while asking for some price reduction as well in order to cover the appraisal gap.
Disputing the appraisal
If the appraiser has made some errors, the buyer and/or seller can appeal the appraisal. The appraiser will require proof/evidence to show that their appraised value was too low. Absent any evidence such as recent sales, some error made by the appraiser (such as undercounting bedrooms, coming in low on square footage, and more) the appeal will be denied. Having the facts presented to the appraiser in a clear, concise manner is vital and your real estate agent should be helping you in preparing the evidence.
What is an Appraisal Gap Clause?
In hot real estate markets, a real estate agent suggest an appraisal gap clause. Appraisal gap clauses are the opposite of an appraisal contingency. A coverage gap clause requires the buyer to pay any gap between the appraisal and the agreedpurchase price up to a particular value. This will mean a specific dollar value is included in the contract, which needs to be paid to close the gap when there is one.
In other words, when there is a gap, a buyer guarantees the seller they will move forward with the sale by increasing their down payment. Though if this value isn’t enough to cover the gap, the other options we’ve discussed can be used to keep the purchase on track. The appraisal gap coverage means the buyer still has to purchase the home when there is a gap. If, instead, there is an appraisal contingency, the buyer can back out of the purchase with their earnest money returned if other options aren’t possible.
If there is an appraisal gap guarantee, contingency, or clause in the purchase contract, the seller will be better equipped to deal with a gap if it happens. An appraisal gap coverage clause isn’t quite the same as a contingency, but it is better than waiving this option entirely and gives some reassurance to the seller.
Appraisal gaps aren’t uncommon, particularly in changing markets. When a potential new home doesn’t appraise, there are have options to keep your purchase on track. With clauses or contingencies in the purchase contract, both the seller have options to protect their interests and ensure the deal remains on track..
- What is Debt to Income Ratio For Mortgage Purposes? - The Debt to Income ratio of DTI is a number that mortgage lenders look at in order to determine if the borrower can afford a certain rental payment.
- What Happens When The Appraisal Comes In Low? - With the market rapidly changing a home coming in appraised under the contract agreed to price can cause stress for both the seller and the buyer. Learn about the options both sides have and both sides will need to work together to come to a resolution.
About the author: The above article “What is an Appraisal Gap Clause?” was provided by Commercial Real Estate Specialist Paul Sian. Paul can be reached at paul@CinciNKYRealEstate.com or by phone at 513-560-8002. If you’re thinking of selling or buying your investment or commercial business property I would love to share my marketing knowledge and expertise to help you. Contact me today!
I work in the following Greater Cincinnati, OH and Northern KY areas: Alexandria, Amberly, Amelia, Anderson Township, Cincinnati, Batavia, Blue Ash, Covington, Edgewood, Florence, Fort Mitchell, Fort Thomas, Hebron, Hyde Park, Indian Hill, Kenwood, Madeira, Mariemont, Milford, Montgomery, Mt. Washington, Newport, Newtown, Norwood, Taylor Mill, Terrace Park, Union Township, and Villa Hills.
Hello, Paul. I appreciate you being aware of this. I don't know what the real value of the property is, but it's not what we agreed to pay for it. However, these gaps are not unusual, as far as I'm aware. What causes an appraisal gap, therefore, and why might this impede a home transaction from going through?
Thanks for your comment. Usually in a market that is changing from sellers to buyers market the value can go down. Sales of other local homes come in lower and get used to value the current home in question. There could also be hidden conditions that were not account for in the purchase price but come to light under the appraisal.
Hopefully as this market returns to a more reasonable one, there will not be as many issues with appraisal valuations.
What sort of issues are you seeing in your area Gabe?
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