It’s a sellers market. And buyers are resorting to all kinds of tactics to make their home bid stand out among the competition. One strategy is to add an appraisal gap clause to the offer.
One of the most common hangups to a home sale is issues with the appraisal, according to a National Association of Realtors survey. Offers that include an appraisal gap clause are more appealing to sellers because it removes a possible hurdle to completing the sale.
With an appraisal gap clause, the homebuyer is committing to cover some or all of a potential difference if the appraised value of a home is lower than what you offered to pay.
When there’s an increased likelihood of a home appraisal coming in below the sale price, an appraisal gap clause can be a useful tool to help get your home offer accepted. But it’s an extra risk for the buyer and depending on the market it isn’t always essential.
For buyers, it’s an extra financial commitment. “It could potentially result in [the buyer] needing to bring in more cash to close to complete the transaction,” says Brian Brown, program performance and quality assurance specialist with the nonprofit financial counseling agency Greenpath Financial Wellness.
It’s a step to carefully consider before taking. Depending on the state of your local housing market or the property you’re bidding on, it may be an unnecessary buyer concession. Let’s take a look at what you need to know about the risks and potential advantages of including an appraisal gap clause in a home offer.
What Is An Appraisal Gap Clause?
An appraisal gap clause is when a homebuyer commits to paying more than the appraised value of a property, if the appraised value is lower than the agreed on price of the home.
The difference between the appraised price and the sale price is important because a lender won’t issue a loan for more than the property is worth or for more than a certain percentage of the home’s value, also known as the loan-to-value ratio (LTV).
Let’s say you have agreed to buy a home for $400,000 with a 10% down payment ($40,000) and a mortgage lender has approved you for a mortgage with a 90% loan-to-value ratio (LTV) of $360,000. If the appraised value of the home comes in at $380,000, then there is a shortfall to make up because the lender will only loan you 90% of the value.
Here a breakdown of what that looks like.
|Mortgage Amount at 90% LTV|
In this example, there is an $18,000 gap that needs to be covered or the deal could fall through. With an appraisal gap clause, the buyer commits to cover a shortfall as part of the initial home offer and before the appraisal is completed.
There are multiple ways you can include appraisal gap coverage in an offer. You could agree to a complete appraisal waiver and agree to cover the difference no matter the amount. A partial appraisal waiver is a way for buyers to limit how much they are required to pay in the event of an appraisal shortfall. Partial appraisal gap coverage can be set at a certain percentage of the purchase price or a specific dollar amount.
When Does Appraisal Gap Coverage Make Sense?
Including an appraisal gap clause in your offer makes sense if you want to make your bid standout and you can comfortably afford it. Homebuyers need to understand what the offer means with or without that appraisal gap clause and what their obligations and commitments are, Brown says.
When considering appraisal gap coverage, you’ll want to start with figuring out how much extra money you’re comfortable bringing to the table. This helps you determine what type of appraisal gap coverage makes sense for you. You can do a complete appraisal contingency waiver but if the home appraises for $50,000 less than the agreed upon purchase price you’re obligated to pay that $50,000, says Shanequa Jones, a licensed Realtor with NB Elite Realty in Houston.
You can limit your risk with partial appraisal gap coverage. If you’re willing to pay an extra $2,000 for the home and not a penny more, then you have the option of limiting your appraisal gap to $2,000, even if the shortfall is larger than that. In this situation, if the seller isn’t willing to accept a lower price to cover a deficit beyond the $2,000, the buyer can back out of the deal without losing the earnest money deposit.
Aside from the financial aspect of an appraisal gap, you’ll also want to understand the local real estate market conditions. In a seller’s market, an appraisal gap may be an essential tool to getting your offer accepted. But when there are fewer buyers in a market and sellers are more desperate, appraisal gap coverage may be unnecessary.
It’s been a strong seller’s market in most areas for the past two years, but each neighborhood and even individual properties will have different levels of competition.
The price range of home could factor into whether or not an appraisal gap makes sense in your area. In Houston where Jones is based, she says there is more competition for lower-priced homes, particularly houses priced under $300,000. “You’re competing against investors and everybody else,” Jones says. But there is less demand for more expensive homes, which puts buyers in a better position to negotiate the terms of the offer. “Once you get over $500,000 that’s when [buyers] can start asking for more,” she says. If you’re shopping for a more expensive home in Houston, it’s less likely you’ll need to add any form of appraisal gap coverage to get an offer accepted.
Keep in mind that for certain government-backed loans, such as VA loans or FHA loans, you cannot waive the appraisal contingency when purchasing a home. Borrowers using these types of loans, “can tell the seller, I’ll cover the difference, but there’s no way that they’re legally obligated to do that,” Jones says.
What Can You Do When the Appraisal Is Less Than the Offer?
When a home appraisal comes in lower than the offer price, the buyer has the option to walk away from the deal, as long as they didn’t waive the appraisal contingency. This is a big reason why appraisal gap coverage is appealing to sellers because the buyer is telling the seller that they’re willing to pay more for the house than what an appraiser says it’s worth.
If an appraisal is low and there was no appraisal gap coverage, here are the buyers options.
Pay the Difference
Even if an appraisal gap clause wasn’t included in the original offer, a buyer can volunteer to pay the entire shortfall. In a hot sellers market where homes regularly receive multiple offers, this may be the one way to get the seller to accept the offer. But typically, you’d want to explore all of your options first and only pay more out of pocket as a last resort.
A low appraisal is an opportunity to renegotiate. Depending on the state of the local housing market, a seller may lower the price to match the appraised value or the buyer and seller could choose to meet in the middle. If there is a $10,000 shortfall, the seller could lower the price by $5,000 and the buyer can agree to pay $5,000 more.
Challenge the Appraisal
If you feel that the appraisal is inaccurate you may be able to challenge the appraisal. Any appraisal dispute or request for a second appraisal must come from the lender.
To begin this process, contact the lender and request a reconsideration of value (ROV). The lender will typically provide you with a ROV form to complete. You’ll also need to document inaccuracies in the appraisal report and provide sales of comparable homes that were above the appraised price.
Cancel the Sale
A typical contract for a home sale will include protections for the buyer known as contingencies. One of these protections is the appraisal contingency, which safeguards the buyer if the appraised value ends up being lower than the contracted sale price. As long as the appraisal contingency isn’t waived, the buyer can walk away from the deal without consequence.