Home buyers and sellers are facing a growing number of difficulties as a result of rapidly rising home prices. 

The agreed-upon purchase price and the home’s appraised worth are the two numbers that matter most when purchasing or selling a house. 

A National Association of Realtors survey revealed that problems with an appraisal are one of the most frequent roadblocks to a property sale. 

In order to build their offer, buyers should consult carefully with their agent or realtor. Read on to learn how likely appraisal gaps are and the strategies to deal with them.

What is an appraisal gap?

An appraisal gap is when the appraised worth of the home is different from the final purchase price that was agreed upon. 

When it comes time to completing the deal, this difference could present significant difficulty. No lender will grant a buyer a mortgage for an amount greater than the home is worth, and no seller wants to sell their house for far less than it is worth.

Fortunately, there are many approaches to addressing an appraisal gap, such as using appraisal gap coverage. 

How likely is an appraisal gap?

When there is a lack of available homes and a high demand for properties, as there has been in the U.S. housing market recently, appraisal gaps become more prevalent. 

In the second quarter of 2021, 1 in 5 applications for home loans had an appraisal gap with an average difference of 4.5% below the buyer’s offer price.

Let’s look at an appraisal gap example

You make an offer of $370,000 on a $350,000 asking price and enter into a contract at that price since there is strong interest from other bidders. 

The value of the house must be determined by an independent appraiser’s opinion in order for your lender to accept the loan application. 

If the appraiser finds that the property is worth $300,000, the appraised difference between the market value and the agreed-upon price is $70,000. 

You, your lender and the seller will now need to decide how and whether the sale will go forward in light of the appraisal gap.

How do you deal with an appraisal gap?

Imagine that you’ve completed an appraisal and discovered an appraisal gap. What now?

Let’s look at a few steps you can take when dealing with an appraisal gap during a home sale. 

Renegotiate With the Seller

You might discuss renegotiating the offer with the seller if the appraised value is less than what you offered. 

Consider making a concession and dividing the discrepancy between the appraised value and your initial offer. Or, you might inquire about the seller’s willingness to lower their price from the offer you made prior to the appraisal.

In some cases, this might be effective, depending on how much competition there is for the house. You might not have any leverage if there is a lot of interest and others have the funds to fill the gap.

Walk away

Although it might not be your first choice, walking away from the transaction can be your best bet if you’re concerned about paying more than the property is worth. It could be advisable to look at other properties if you’ve tried to negotiate with the seller again without success and have unsuccessfully contested the appraisal.

Pay the difference anyway

The simplest solution to an appraisal gap is for the buyer to cover the difference, especially when the seller refuses to renegotiate. 

You might even be obligated to pay the difference unless your contract includes an appraisal contingency. The appraisal contingency allows you to exit the contract without forfeiting your earnest money. 

Contest the appraisal

When you’re pre-approved for a mortgage, the lender usually determines who will appraise the house. Suppose you believe the appraised house value is significantly lower than you anticipated (and would force you to pay significantly more than you agreed to in your offer). In that case, you can dispute it with your lender and request a new appraisal.

In the dispute, you must mention any information you believe was overlooked in the final evaluation, thus lowering its worth.  Getting a new appraisal  may be an ideal alternative. 

Is appraisal gap coverage a good idea?

If you want to make your bid stand out and you can afford it, it makes sense to include an appraisal gap clause in your offer. This is a special condition in the purchase agreement that states you’ll cover the difference between the appraised value and the contract price up to a predetermined limit. 

Appraisal gap coverage binds a buyer to the purchase; however, a contingency clause can be included to protect the buyer. 

Homebuyers must understand the implications of the offer—both with and without the appraisal gap condition—as well as their responsibilities. 

When thinking about appraisal gap coverage, you should first decide how much more cash you feel confident contributing. This allows you to choose the kind of appraisal gap coverage that is appropriate for you. 

An appraisal gap contingency gives a legal way out of a sale contract, including the ability to reclaim earnest money.  Without an appraisal contingency, you risk losing your earnest money deposit, which is held in an escrow account. Earnest money is typically 1% to 5% of the buying price, which is a lot of money one wouldn’t want to lose on a whim.

However, appraisal contingency cannot hold up when purchasing a home with government-backed loans, such as VA or FHA loans. While borrowers using these loans can agree to cover the difference, they are not legally required to do so.

How do I get appraisal gap coverage?

You may lose your ideal home if there is an appraisal gap unless you work with your agent to include appraisal gap coverage into your purchase contract.

In a seller’s market, it’s not uncommon for a seller to require an appraisal clause in the contract that stipulates that the buyer must cover the difference. 

In a less-competitive market, however, it’s advised to work with the seller and work out a solution that works for everyone and include it in the contract. Your agent should work with theirs to make this happen. 

Appraisal Gap Coverage with Compass Mortgage

As a home buyer, and especially in a competitive market, it’s crucial to protect yourself before entering the contract. 

You can better prepare by coming up with a strategy for the possibility we’ve just described before you begin your house hunt. Although buyers have numerous options, you should always go with the one that makes you feel the most comfortable.

Talk with a Compass Mortgage loan specialist today about protecting yourself if an appraisal gap becomes a reality.

We’ll provide the personalized and expert experience you need as you buy in today’s—or any—market. 

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