What is an appraisal gap and how does it affect your mortgage?

In real estate, there can be times when some things do not go as planned. One such example of this is the occurrence of an appraisal gap. This happens when the purchase price on a property is higher than what the home is worth.

The presence of this gap when purchasing a property via mortgage is important mainly because this has a significant impact on mortgage financing. Most mortgage lenders hesitate to push forward with clients buying a home or other properties that have appraisal gaps for valid reasons. If your client bought a property at a higher price than its appraised value, then the mortgage lender’s financing would be riskier and alter the loan amount. What are the buyer’s and mortgage lender’s options in these situations?

In this article, Mortgage Professional will shed light on how to deal with this scenario, so be sure to share this with your client if they’re purchasing a property via mortgage. This could prove valuable information if their property purchase results in a wide appraisal gap. We’ll provide insights into questions: 

• Why do appraisal gaps occur?
• What is an appraisal gap clause?
• What is appraisal gap coverage?

What is an appraisal gap and why does it happen?

An appraisal gap occurs when a property is listed at a certain price, but the appraisal shows that the sale price is at a different, higher value compared to its appraised value.

The difference between the appraised value and the purchase price the buyer agreed to pay is the appraisal gap. Typically, a licensed professional appraiser would assess the value of the property for the mortgage lender.

In hot real estate markets, appraisal gaps can be quite common. Property prices rise sharply when the number of buyers is greater than the inventory of properties available on the market. In this situation, appraised values may be unable to keep up with property prices rising faster than recent sales for comparable properties.

For example, if a home is listed at $350,000 and the buyer agrees to pay that amount, but the appraiser values the home at only $320,000, then there is a $30,000 appraisal gap.

Are appraisals necessary in real estate?

Yes, because it is standard practice to do appraisals on property purchases, unless the purchase is on a cash basis. Home appraisals serve as an important safety net for the lender and the homebuyer. This works by keeping both parties from overpaying by using a systematic valuation process.

For homebuyers, an appraisal determines the value of the property you are buying, protecting you financially. This is especially important if there is a significant difference between what you agreed to pay and the value of the property.

As for mortgage lenders, an appraisal confirms that the sales price is accurately aligned with the property’s value based on its location, condition, and its features. Your mortgage lender will also be able to determine if your property can be sold to cover any losses in case the mortgage goes into default.

But perhaps more importantly, there are several laws that provide a legal basis for having properties appraised when purchased with a mortgage. The laws in the US that govern appraisals include:

1. The Truth in Lending Act (TILA)

This act rules that lenders must provide borrowers with timely, accurate disclosures about the costs and terms of their loans. Note, however, that this applies mostly to higher-priced mortgage loans. TILA requires appraisals to make certain that borrowers understand the value of the property they are financing.

Are appraisals necessary in real estate?

RESPA requires that mortgage lenders remain transparent about the costs associated with real estate transactions, which also covers the necessity of property appraisals.

3. Regulation B or Equal Opportunity Act

This rule includes provisions that ensure that all applicants of credit who use a dwelling as security for the loan receive their appraisals promptly. Such an appraisal is crucial for credit applicants of this type. Regulation B is there to ensure they understand the equity involved in the transaction.

4. Federal Housing Administration and Department of Veteran Affairs

Should a home buyer take loans from these government agencies, appraisals are required. FHA and VA appraisals are necessary to meet their compliance rules and standards, as well as protect federal investments.

How to handle an appraisal gap

An appraisal gap can up-end a property purchase. In some cases, this can affect the transaction considerably and make both the buyer and seller rethink the terms of their contract. Fortunately, appraisal gaps are not uncommon and there are strategies to lessen their impact or fix them. Here’s what you can do:

1. Pay the gap

The simplest way to address a gap between the purchase price and the appraised value is for the buyer to pay for the difference in cash. Financially speaking, this is not always the ideal or possible strategy, especially if the buyer lacks funds. If the buyer is comfortable doing so, they may take out a separate loan to pay for the difference, or access retirement funds (without penalty, if possible).

2. Pay the higher monthly payments

Another option is for the buyer to agree to pay higher-than-expected monthly payments on their mortgage. In this case, the lender may agree to a small downpayment to make monthly payments less burdensome for the buyer. Under this arrangement, it may be necessary for the buyer to obtain private mortgage insurance for the lender and protect their interest in the property, in case of default by the buyer.

3. Renegotiate the sale

To address the gap, buyers have the option of renegotiating the purchase price. This option can be especially important if there is a contingency in the contract, such as an appraisal clause.

It may be possible to ask the seller to lower the property’s purchase price to match the appraised value, which the seller may do, depending on their investment in the property and if they are motivated to sell. You may also try to ask them to split the difference and cover the gap or meet somewhere down the middle and reduce the gap to more affordable levels.

4. Dispute the appraisal

It’s also possible to reject and dispute an appraisal, although it requires substantial evidence to prove that errors were made in the appraisal. Alternatively, the buyer can dispute the appraisal and say that the appraiser failed to properly assess the property and misquoted its value; this also requires substantial evidence.

Disputing the appraisal may also be complicated, as even the government is stepping in to ensure that property appraisals are less biased.

But if there were indeed lapses in the appraisal and the dispute succeeds, the buyer can then seek new financing, as well as request for a new appraisal. This might result in an appraisal that is more aligned with the contract price of the property, but this is not guaranteed. Keep in mind that this can be a very time-consuming option. The seller may not be open to appraisal disputes either, even more so if the housing market is rife with bidding wars.

5. Cancel the sale

The last and most extreme option is to cancel and walk away from the sale. This can happen if the seller and the buyer cannot agree to split the appraisal gap. Terminating the sale can also result if the buyer does not wish to renegotiate the price or if the seller believes that their property has been undervalued.

Appraisal gap coverage

As an appraisal contingency, some buyers can include an appraisal gap clause in their contract. Since appraisal gaps can become quite common in hot real estate markets, including this clause makes sense – for both the buyer and seller.

The clause’s purpose is to express the buyer’s willingness to cover the difference between the appraised value and the contract price that was agreed upon, if a gap should arise.

For example, if a buyer agrees to purchase a home for $350,000 but the appraiser says that the home is worth $320,000, then there is a $30,000 gap. Gap clauses for the same amount can typically cover this if it’s in the contract – if the $30,000 is what the buyer can afford and stipulates this as the limit for coverage.

This clause can be very beneficial to serious buyers, even in competitive real estate markets. Inserting such a clause in the contract can help buyers stand out from other bids for a property.

This video offers useful tips on how to deal with substantial gaps in appraisals. Watch the entire video to know more about these gaps, how to insert them in your contract, why gap clauses are a good idea, and what sellers think about them.

Benefits of the appraisal gap clause

For buyers:

Competitive offers

Inserting an appraisal gap clause can make a buyer’s offer for a property more attractive. This is even more evident in a competitive housing market. A gap clause can demonstrate a buyer’s willingness and financial capacity to close the sale.

Streamlined business dealings

Buyers who put in an appraisal clause avoid tedious and lengthy negotiations if the property’s appraised value is lower than predicted. A gap clause does away with renegotiating the contract price if the gap is within the limit specified in the clause.

For sellers:

Less risk of sales falling through

A gap clause reassures sellers that the sale can go smoothly, even if the appraisal of their property is lower than their asking price. Offers with this clause can convince sellers to go ahead with the sale despite the gap, knowing that the buyer is committed to proceed with the sale.

Savings on costs and time

When the seller is confident that the buyer can and will cover the appraisal gap, this saves them the trouble of re-listing the property and finding new potential buyers.

Who benefits from the clause more?

The party that reaps more benefits largely depends on the prevailing market conditions.

• In a seller’s market – the gap clause benefits sellers, since it provides reassurance that buyers are willing to cover any appraisal gap that may arise. This can translate into higher sale prices and it’s less likely for sales to fall through.
• In a buyer’s market – the clause can benefit buyers more, as it serves as a protective measure from potentially unexpected renegotiations. Buyers who include the clause can ensure their offers are more attractive, greatly boosting their chances of buying the property without making a significant overpayment.

At the very least, an appraisal gap can cause a temporary inconvenience. But at its extreme, it can cause property sales to completely fall through. The key is to track the market conditions and prepare for unexpected gaps with a feasible contingency clause in your purchase contract.

Even if the gap is substantial, you don’t have to walk away from the transaction whether you are the buyer or seller. If you’re finding a home for a client, not buying a home may not be an option for them, especially if it’s a hot market. There’s no rule that prevents you from renegotiating the price, the downpayment, the monthly payments, or other terms. You can also ask for a new appraisal if you suspect errors or other missteps on the appraiser’s part. Keep in mind that mortgage lenders won’t approve a loan amount that’s higher than the home or property’s appraised value, so it’s important to prepare for an appraisal gap.

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Were you ever in a situation where your client faced an appraisal gap on their property purchase? What options did you recommend and what options did they take? Tell us your story in the comments.