Homebuying involves a dizzying array of numbers, from loan-to-value ratios (LTVs) and interest rates to down payments and closing costs. However, the two that matter most are the agreed-upon purchase price and the home's appraised value. When these figures don't align, there's an appraisal gap, which can complicate the sale process.
Here's what you need to know about appraisal gap clauses, including what they are, how they work, and your options for completing the purchase.
What is an appraisal gap?
An appraisal gap occurs when the agreed-upon purchase price is higher than the appraised value of a home. Appraisal gaps are common in hot real estate markets where conditions change rapidly and bidding wars drive up prices. While an appraisal gap can disrupt the real estate sale process, it won't necessarily derail it. Still, you'll need to renegotiate with the seller, pay the difference, or successfully dispute the appraisal to get the home buying process back on track.
How do appraisal gaps work?
Among other details, a real estate purchase and sale agreement (PSA) specifies a purchase price: the amount that the buyer and seller agree the home is worth. If you're financing the purchase with a mortgage, your lender will require an appraisal to confirm that the price makes sense (and the property is a good investment). The appraisal determines the home's value based on what similar homes in the area have sold for recently.
If you have an appraisal gap there are a few options:
- Renegotiate with the seller—Ask the seller if they'll lower the price to the appraised value or meet you in the middle. For example, if there's a $20,000 appraisal gap, the seller could reduce the price by $10,000, and you could increase your down payment by an equal amount. This option may not work in seller's markets or if the seller has competing offers.
- Pay the difference in cash—If you're a cash buyer, you can pay more if you have the funds. If you need a mortgage, you'll have to bring more cash to the closing table—your down payment plus the gap (or the amount written into your appraisal gap clause, if you have one). Your lender may offer programs that allow you to put down less money, but you could face additional monthly charges from private mortgage insurance (PMI).
- Dispute the appraisal—If you don't agree with the home value, you can dispute the appraisal in writing, but you'll need to provide proof to back up your claim. For example, you could show that the appraiser didn't use appropriate comparables, missed some of the home's features or upgrades, miscalculated the home's living area, or conducted a drive-by appraisal.
- Walk away—You can keep your earnest money if you have an appraisal contingency in your contract. Otherwise, you'll forfeit your deposit.
Appraisal gap example
Let's say you want to buy a home with an asking price of $400,000. Your real estate agent submits an offer on your behalf for the full amount, and the seller accepts. However, your lender's appraiser says the home is worth just $380,000—meaning there's a $20,000 appraisal gap.
The seller may not accept less than you offered, and your lender won't lend more than the home is worth. What happens next depends on whether your PSA includes an appraisal gap coverage, appraisal gap clause, or appraisal contingency.
Appraisal gap coverage vs. appraisal contingency
PSAs often include language to specify what happens if there's an appraisal gap, including appraisal gap coverage, an appraisal gap clause, and an appraisal contingency. While they sound similar, they're different. Here's a quick rundown:
- Appraisal gap coverage binds you (the buyer) to purchase the home at the agreed-upon purchase price even if the appraisal is lower than expected.
- An appraisal gap clause says you agree to pay the difference between the appraised value and the agreed-upon price—up to a certain amount (think of this as a middle ground between appraisal gap coverage and an appraisal contingency). You can specify any amount that works for your budget.
- An appraisal contingency gives you the right to cancel the contract and keep your earnest money if the appraisal is lower than the agreed-upon purchase price. Earnest money is a deposit you give the seller to show you're serious about buying; it's typically about 1% to 3% of the agreed-upon price (or $4,000 to $12,000 on a $400,000 home). Without an appraisal contingency, you would forfeit the earnest money.
When is an appraisal gap coverage clause necessary?
No buyer wants to overpay for a house, but it’s sometimes necessary in a fast-moving seller's market. An appraisal gap clause makes your offer more attractive because it assures the seller that the sale can progress even with a low appraisal.
This can be especially important in hot real estate markets where bidding wars drive up prices. Be sure the wording in the appraisal gap clause reflects how much you're willing to pay above the appraised value or if (and how) you and the seller plan to split the difference.
Frequently asked questions (FAQs)
What happens if you waive the appraisal contingency?
An appraisal contingency gives you the right to end the contract and get your earnest money back if the appraisal is lower than the purchase price. Waiving the appraisal contingency can strengthen your offer in a competitive market. However, you'll forfeit your earnest money if the appraisal is low and you're unwilling or unable to pay the difference.
Can the buyer back out with an appraisal gap clause?
An appraisal gap clause binds the buyer to purchase the home even if the appraisal is lower than the agreed-upon purchase price. If the buyer backs out, they forfeit their earnest money deposit, and the seller could sue for breach of contract (though this is rare).
Should you pay over appraised value?
In a competitive market, it's easy to get caught up in a bidding war. However, before you agree to pay over the appraised value for a home, pause and consider the following:
- Is this my dream home? Decide if you love the home or if fear of missing out (FOMO) or desperation is driving the purchase.
- Can I afford it? You have to pay the difference in cash if the appraisal is low. Consider how that will affect your financial situation and whether it's worth draining your savings.
- Can I afford to sell it? If you plan to sell within a few years, you may not have time to gain sufficient equity to cover the closing costs.
If you really love the home and can comfortably afford the added costs, paying over the appraised value might be worth it to get into the home of your dreams.
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