Beware The Dreaded Appraisal Gap: What It Is And What To Do About It

The appraisal gap is a frustrating roadblock that commonly arises during the home buying process. We’ll explain what an appraisal gap is and what you can do to potentially resolve it.

What is An Appraisal Gap?

An appraisal gap occurs when the appraised value of a home comes in below the purchase contract price. Appraisal gaps are a problem mainly when you’re financing a home purchase, but they can cause problems for cash transactions as well.

If you’re using a mortgage to purchase a home, an appraisal gap can increase the amount of money you’ll need to bring to closing.

Mortgage lenders base their loan amount on the lesser of the contract price or the appraised value. If the appraisal comes in less than the contract price, the lender will reduce the loan amount, which increases your cash to close. We’ll cover some examples of how this works in a moment.

If you’re paying cash, an appraisal gap isn’t as big of a problem because there’s no financing involved. You’ve already agreed to pay the contract price in cash, but you’ll have to decide if it’s worth potentially overpaying for the home.

Appraisal gaps are frustrating because they gum up the works of an already complex and often stressful homebuying process. To resolve the appraisal gap, you’ll have to either bring more money to closing, renegotiate the sales price, or dispute the appraisal – or maybe some combination of all three.

If you can’t resolve the appraisal gap, you may have to walk away from the purchase altogether.

Why Appraisal Gaps Happen

There are a lot of reasons why an appraisal gap might pop up in a purchase transaction, but here are the most common ones:

• Seller’s market – If inventory is low and demand is high, buyers may engage in bidding wars. We saw a lot of that during the pandemic. Appraisers develop their opinion of value based on recent sales of similar properties in the area. If the sales price is bid up beyond what similar homes are selling for, there’s a good chance of an appraisal gap.
• Buyer’s market – If you’re buying into a declining market, home values may fall during the time between the signing of the purchase contract and the appraisal. If the appraiser uses comps that sold for less than the contract price, it could result in an appraisal gap.
• Property condition – An appraisal could come in lower than the contract price if the home requires extensive repairs or has significant structural issues that were not accounted for in the purchase price.
• Bad location – If the property is located near busy highways, industrial zones, or commercial zones, it could appraise for less than similar homes with better locations. The influence of location isn’t always as obvious to a buyer as it is to a professional appraiser, so a bad location could increase the odds of an appraisal gap.
• Unique property features – Properties with unique features or characteristics that are not easily compared to other homes in the area (such as dome, log, or berm homes, unconventional layouts, highly customized amenities, etc.) can also result in appraisal gaps. Homes with unique features are often less desirable to the average buyer, which means they can appraise for less than expected.

Appraisal Gap Examples

To see how appraisal gaps work, let’s check out some examples. Let’s assume you have a home under contract for $300,000 and your lender is willing to finance 80% of the purchase price. The loan amount would be calculated as follows:

$300,000 (purchase price) *  80% (LTV) = $240,000 (loan amount)

Now, let’s assume the appraisal comes in low at $290,000, which results in an appraisal gap of $10,000. The lender would recalculate the loan amount as follows:

$290,000 (purchase price) *  80% (LTV) = $232,000 (new loan amount)

Again, lenders figure loan amounts based on the lesser of the appraised value or the contract price. If the appraisal comes in lower than the contract price, the lender will reduce their loan amount.

Because the loan amount is lower, you would have to bring additional cash to closing:

$240,000 (old loan amount) - $232,000 (new loan amount) = $8,000 (additional cash to close)

As you can see, the reduced loan amount increases your cash to close by $8,000.

This is why appraisal gaps are such a headache for buyers using financing. The reason they’re using financing in the first place is because they don’t have tons of cash laying around it. That means it can be tough to come up with additional cash to cover an appraisal gap.

Now, what if you’re paying cash and the appraisal comes in low? How does that work? Well, let’s check out an example. Let’s again assume you have a home under contract for $300,000 and you plan to pay cash to cover the purchase and all closing costs.

Let’s also assume that you request an appraisal and it comes in at $260,000. Because there’s no financing, the appraisal gap doesn’t create any roadblocks in the process. You’re already under contract for $300,000 and planning to pay cash, so the appraisal coming in low doesn’t change anything. You just have to decide if it’s worth paying $40,000 more for the home than it may be worth.

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How to Resolve an Appraisal Gap

Yes, it’s frustrating when an appraisal gap arises during the home purchase process. However, you may have a few options to resolve it:

• Bring more cash to closing – If you have the money, you can just bring in additional cash to close the deal. Keep in mind that this typically only applies if you’re using a mortgage.
• Renegotiate the purchase price – Ask the seller if they’re willing to reduce their purchase price to the appraised value or somewhere in the middle. Keep in mind that you may not have a lot of negotiating power if you’re buying into a sellers market and the seller has other competing offers. 
• Dispute the appraisal – This is often easier said than done, but it’s an option. In my years as a mortgage professional, I’ve been able to successfully dispute appraisals and get more value for my clients. Keep in mind that you can’t ask the appraiser to increase the value, you can only give them additional information to consider. In other words, if you know of recent sales of similar properties in the area that were not included in the appraisal, you can ask the appraiser to consider them also. If they’re good comps and they sold for more than the appraised value, you may be able to reduce or eliminate the appraisal gap.

If you can’t resolve the gap, the only remaining option is to walk away from the deal. Keep in mind that you may forfeit your earnest money deposit if you don’t have an appraisal contingency written into your contract.

Appraisal Gap Coverage vs. Appraisal Contingencies

Sellers are often concerned about appraisal gaps as well. They know that if the appraisal comes in significantly lower than the contract price, there’s an increased chance the buyer will back out of the transaction. This is why sellers often like to see appraisal gap coverage or appraisal contingencies written into offers.

If you’d like to strengthen your offer, you may consider including appraisal gap coverage or an appraisal contingency in your offer. Here are a few different types of clauses that are commonly written into purchase agreements:

• Appraisal gap clause – This type of clause states that you agree to pay the difference between the appraised value and the contract price up to a certain dollar amount. An appraisal gap clause can help strengthen your offer if you’re competing against other potential buyers.
• Appraisal gap coverage – This type of clause commits you to purchasing the home even if the appraisal comes in lower than expected. Keep in mind that there could be some risk here; if the appraised value comes in significantly lower, you could be on the hook to overpay for the home by a large amount. However, this kind of clause often makes an offer more attractive to a seller in a competitive sellers market.
• Appraisal contingency – An appraisal contingency enables you to cancel the purchase contract and keep your earnest money if the appraisal comes in lower than the contract price. If you’re competing with other potential buyers, an appraisal contingency could make your offer less compelling than offers without appraisal contingencies.

We’re not real estate professionals, so we highly recommend consulting with a licensed real estate agent about whether or not to use appraisal gap coverage, an appraisal gap clause, or an appraisal contingency in your offer.

Appraisal Gap Calculators

Calculating an appraisal gap is super easy. It’s not something for which you need a special calculator. Here’s the formula to follow:

Purchase Price - Appraised Value = Appraisal Gap

Now, how the appraisal gap impacts the transaction depends on whether or not you’re using financing.

If you’re purchasing with a mortgage, the lender will likely reduce the loan amount based on the lower appraised value. That means you’ll have to come up with additional cash at closing – in addition to your down payment and closing costs.

If you’re purchasing with cash, obviously, there’s no financing to worry about. However, you’ll have to decide if it’s worth paying more than the appraised value for the home.

If it’s not worth it, you can either renegotiate the purchase price or walk away from the transaction altogether.

Appraisal Gap Clause Example

Again, we’re not real estate professionals,. We highly recommend working with a qualified real estate professional to determine the best appraisal gap language to add to your offers.

Having said that, we’re happy to provide an example from a reputable source. Here’s an appraisal gap clause example suggested by Bill Gassett of Maximum Real Estate Exposure:

BUYER has waived their appraisal contingency and acknowledges that if their lender’s appraisal does not equal at least the purchase price herein, the BUYER will pay the difference in funds between what the lender is willing to lend and the purchase price herein to obtain their financing approval.

Any condition in BUYER’s commitment or denial letter related to the appraised value or lack of BUYER funds available to make up the difference shall not be construed as a valid reason for BUYER to void this agreement and for deposits to be refunded.

https://www.maxrealestateexposure.com/appraisal-gap/

Gassett notes that this example doesn’t include a cap on the amount of funds you’re willing to bring to closing to cover an appraisal gap. It may be smart to add a cap to make sure you’re not on the hook for a large amount of money if the appraisal comes in drastically lower than the contract price.

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