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Home buyers today are navigating one of the most competitive real estate markets in history. With home values rising over 17% year over year, home buyers have learned they need to come in with their best offer if they want a chance at winning a home.
Unfortunately, it’s not as simple as making an offer above the asking price (listing price) and paying a bit more than the home is worth. To make sure their investment is sound, lenders will require an appraisal of the house before they provide financing. This is where things can get tricky for home buyers.
An appraisal gap is the difference between the appraised value of a home and the accepted offer price. To avoid an appraisal gap, home buyers will want to consider a few things, but including an appraisal gap clause in your offer is the most effective solution. This tactic can protect you as the buyer, and in the current housing market, buyers can use all the help they can get!
What Is an Appraisal Gap?
An appraisal gap happens when the home’s appraised value is less than what you’ve agreed to pay for it.
To finance a home, your mortgage lender will require a home appraisal to get an estimate of a property’s fair market value. The appraisal assures the lender that the house is worth at least as much as the loan amount being requested.
During the appraisal process, the appraiser will look at the size of the home, recent comparable sales in the area, any upgrades or renovations that have been made and more. When finished, the appraiser will provide an appraisal report that details their estimate of the property’s value.
In a perfect world, the home would be worth slightly more than the accepted offer, leaving no reason for the lender to be concerned. But when an appraisal comes back lower than the agreed-upon purchase price for the home, you’re faced with an appraisal gap.
What Is an Appraisal Gap Clause?
Appraisal gaps are most likely to happen in a seller’s market when buyers need to sweeten the deal however possible. The most obvious way to win bidding wars is to offer more money, which can also work against you. If you offer more than the home is worth and cannot satisfy the appraisal gap, the deal is at risk of falling through. Not only that, but any other offers that were made are lost, too. So the seller is back to square one.
This is where an appraisal gap clause (also known as an appraisal gap coverage clause or appraisal gap guarantee clause) comes in handy.
An appraisal gap clause states that a buyer will contribute additional funds, up to a specified amount, beyond the appraisal amount. Informing the seller that you are able, willing and prepared to pay above the appraisal amount is a strong negotiating tactic that could seal the deal in your favor.
Appraisal gap clause vs. appraisal contingency
Again, an appraisal gap clause states that a buyer will contribute a specific amount of additional funds beyond the appraised value of a home.
An appraisal contingency, on the other hand, is a clause that allows the buyer to back out of the deal if the appraisal is low – that is, if the appraised value of the home comes in below the contract price. This contingency protects buyers from overpaying for a home.
What Are Your Options When There Is an Appraisal Gap?
If you find yourself dealing with an appraisal gap, there are a few options you can pursue.
Include an appraisal gap clause
The best way to deal with an appraisal gap is to be prepared for one. An appraisal gap clause will show the seller you’re serious about buying the home and are willing to pay more than the appraised value if necessary. This will give you a leg up in a bidding war and prepare you for this financial possibility.
Pay the difference
If you didn’t have an appraisal gap clause, your next best option is to pay the difference. If it’s affordable, it will allow you to move forward with the home purchase and avoid further delays.
If you don’t have the cash on hand, consider other options available to you. You aren’t prevented from utilizing gift funds for an appraisal gap like you can be for your down payment with some loan types.
Renegotiate the offer with the seller
If you don’t want to or can’t afford to pay the difference, you can try to reach a new agreement. You can negotiate an appraisal gap by lowering your offer, splitting the difference, requesting buyer assistance or walking away from the deal entirely.
However, negotiations can be a risky option, especially in a seller’s market. In a competitive market, sellers are liable to move on to another buyer rather than risk ongoing delays and negotiations.
Decrease your down payment
When you can’t afford to pay the entire appraisal gap, you may be able to use some of the funds intended for your down payment.
For instance, say you planned to put down 20%, but your U.S. Department of Agriculture (USDA) home loan doesn’t require any down payment. So you use some of that toward your appraisal gap. This isn’t without drawbacks, as a lower down payment can result in a higher interest rate or mortgage insurance expense.
Dispute the appraisal
Time is usually of the essence during a home purchase, especially in a seller’s market. However, if you have time on your side, you could attempt to dispute the appraisal. If you saw comparable sales the appraiser didn’t utilize or felt there was some other factor the appraiser overlooked, you could attempt to have the appraisal value reconsidered.
To do this, you’ll need to contact your mortgage lender and request a Reconsideration of Value (ROV).
Get a second appraisal
A second appraisal is another option to consider if you have the time. You’ll have to pay for it, but it could be worth it if the new appraised value comes in closer to your offer price. However, buyers can’t request a second appraisal just because they disagree with the first. You’ll have to work with your real estate agent and lender to demonstrate that the appraiser has made an error.
Remember that a second appraisal may need to be agreed upon by your lender and the seller, and there’s no guarantee the new appraised value will be any different.
Walk away from the deal
If you can’t afford the other options or reach an agreement with the seller, you may have to walk away from the deal. If you don’t have an appraisal gap contingency in place, you may wind up forfeiting your earnest money deposit. Losing out on a home purchase and your deposit is a frustrating, unfortunate situation, but it may be worth it to avoid overpaying for a home.
Should You Include an Appraisal Gap Clause in Your Offer?
You should add an appraisal gap clause to your offer during a seller’s market or when purchasing a home for an amount above fair market value. The clause is helpful for you as the buyer because your willingness to pay above the appraised value gives you an edge over others.
The clause also brings clarity to an otherwise unknown part of the home sale. With the appraisal gap clause in place, you and the seller have communicated and documented how much you’re willing to pay and if they’ll need to revise the sale price.
Make Your Offer Stand Out from the Crowd
When you’re in a bidding war, you need your offer to stand out. An appraisal gap clause will do just that – show the seller you’re ready and able to pay a premium for the home.
Your agent can present the appraisal gap clause in the initial purchase offer along with any other contingencies you may have, such as a loan or inspection contingency. By including it early on, you show you’re a serious buyer who’s willing to do what it takes to close the deal.
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Federal Housing Finance Agency. “U.S. House Prices Rise 17.5 Percent over the Last Year; Up 3.3 Percent from the Third Quarter.” Retrieved July 2022 from https://www.fhfa.gov/Media/PublicAffairs/Pages/US-House-Prices-Rise-17pt5-Percent-over-the-Last-Year-Up-3pt3-Percent-from-the-Third-Quarter.aspx