The concept is becoming increasingly relevant in the current market
Almost all mortgage applications require a home appraisal. Lenders typically want to see an appraised value that is either equal to or greater than the agreed price between the homebuyer and the seller. Occasionally, however, the appraisal comes in lower. Here is how that appraisal gap can affect your mortgage—and some options that could preserve the deal and save you money.
What does an appraisal gap mean?
An appraisal gap is when the appraised value of a property for sale is lower than the contracted purchase priced that was agreed upon by the seller and the homebuyer. In hot real estate markets, appraisal gaps are quite common. Property prices rise sharply when the number of buyers is greater than the inventory of properties available on the market. Appraised values struggle to keep pace when property prices rise faster than recent sales for comparable houses.
An example of an appraisal gap is if you want to purchase a property that is on sale for $300,000 and you offer $325,000 with a 5% down payment, as a means of standing out from the crowd. After your offer is accepted, the appraisal comes back at $305,000. You will be on the hook for those additional funds unless the seller agrees to lower the price.
Are appraisal gaps necessary in real estate?
Your lender will ask you to do an appraisal unless you are paying cash for your new property. Home appraisals are an important safety net for the lender and the homebuyer 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.
On the lender side of the equation, an appraisal confirms that the sales price is accurately aligned with the property’s value based on location, condition, and features. Your lender will also be able to determine if your property can be sold to cover any losses in case the mortgage goes into default.
How does the appraisal gap affect your mortgage?
What happens if the appraisal is lower than the mortgage?
You have options in this scenario. Firstly, you have the option to pay the difference in cash between the appraised value and the amount of your offer. Another option is simply to walk away, which would work if you have an appraisal contingency in your purchase contract. The remaining three options open to you are to renegotiate with the seller, request a review of the appraisal if you find inaccuracies, or apply with another lender that will hire an appraiser who will value the property in your favour.
The final three options can preserve the deal or save you money. They could, however, be less practical if there are more homebuyers than sellers, otherwise known as a seller’s market. A seller’s market typically leaves homebuyers with less room to negotiate.
There are instances when a seller may not budget if asked to lower the price to the appraised value. If the seller is impatient, they may reject a request to seek an appraisal review. The seller could also reject the idea of starting a loan with a new lender, since it usually causes delays.
Negotiation with the seller.
If you choose to negotiate with the seller, you may be able to lower the price. You could ask the seller to split the difference or to cut the price to the appraised value. If there are competing offers, however, negotiating with the seller is more unlikely. After all, the seller could opt out entirely and take the next-best offer. In a seller’s market where there are numerous competing offers, negotiation with the seller could be risky.
Things you need to do when dealing with an appraisal gap
There are an additional three things you can do when dealing with an appraisal gap. The first is to decrease your down payment percentage and use the extra money to cover the appraisal gap. For example, let’s say you put down 20% on a $400,000 offer, $80,000 out of pocket, but the appraised value is $380,000. If you use $20,000 of that $80,000 for the appraisal gap, you will be left with $60,000, or 15%, of a down payment. You should know, however, that if you pay less than 20%, you will have to get mortgage insurance, if only temporarily.
Another option is to include an appraisal gap clause, which will protect the homebuyer and seller from having to renegotiate their purchase agreement if the appraisal is lower than expected. Finally, you have the option to terminate the contract, assuming you are within the appraisal contingency period. While this is usually the less appealing option, it may be the only one if the above strategies fail.