Understanding An Appraisal Gap and How it Works
During a seller's market, the competition between buyers can be brutal and sellers tend to ask more for their home because buyers will pay it. Unfortunately, this can become an issue when the appraisal is performed, and the price of the home is higher than the appraisal value.
Mortgage lenders are not going to loan a buyer more than the home appraises for, when the appraisal amount is less than the sale price, this is known as an appraisal gap.
To better understand and potentially give you more leverage, let's break it down.
Lenders will require a home appraisal to ensure that the home value is high enough in case you default on your loan, so they need to be certain that the fair market value is equal to the loan amount.
A licensed appraiser will evaluate the condition of the home and comparable homes in the area that has been sold within the last six months to determine the fair market value. The difference between the home's value versus the loan amount can determine how much you are allowed to borrow.
If the home appraises for less than the sale price, the buyer will have to make up the difference.
A pitfall to paying more than the appraisal price, aside from being out more money upfront, the buyer will start out having negative equity.
What Are Your Options?
The appraisal has come back less than the sale price, what are your options? Let's review.
- Pay the Difference - Paying the difference is the quick answer, unless you have an appraisal contingency that will allow you to walk away unscathed, paying the difference may be your best option. Walking away without an appraisal contingency, you will be walking away without your earnest money.
- Renegotiate Your Offer - If your sales contract has an appraisal contingency, try to renegotiate before making a quick decision. Asking the seller to reduce their price to match the appraisal is ideal but, not always possible. If the seller isn't willing to budge on the price, ask them to split the difference. Attempting to renegotiate does not come without risk, if the seller has a kick-out clause, they can simply move on to another offer.
- Dispute the Appraisal - If the buyer or seller does not agree with an appraisal, they can dispute the appraisal, requesting a reconsideration of value. However, in doing so there has to be evidence to prove the inaccuracy. To dispute an appraisal, a written letter must be submitted explaining why they are disputing the appraisal. The proof submitted for the dispute to be considered inaccurate, the evidence must prove:
- Comparable sales used were not appropriate - proof of more accurate comparable sales must be provided
- Features or Upgrades were missed or simply not considered
- Mistakes were discovered in the report
- Only an exterior appraisal was conducted
- Walk Away - Walking away is a viable option and may be the only solution remaining, even if it's not the choice you wanted to make. After unsuccessful renegotiations and/or a failed appraisal dispute, walking away may be the best option rather than paying more than the property is worth. However, if there was not an appraisal contingency in your contract, you may want to consult your attorney for legal counsel. Other contingencies could help if an appraisal contingency was not included in the contract.
Gap Coverage vs. Contingency
Common terms you may hear when purchasing a home are Gap Coverage and Appraisal Contingency. They sound similar but, they carry a different meaning, you'll want to know and understand the difference.
Sellers are at an advantage with Appraisal Gap Coverage, it binds the buyer to the home sale even if the appraisal is lower than the sale price. The seller can ask for it to be completely removed from the contract or at least put a cap on the amount you are willing or able to pay over the appraisal amount.
When a buyer includes an Appraisal Contingency, if the agreed-upon sales price does not match the appraisal price, the buyer is legally protected to enable them to back out of the deal and take their earnest money with them. If there isn't an appraisal contingency, backing out of the contract could cost the buyer their earnest money deposit, which is usually 1% - 3% of the sales price.
Appraisal Clause - When is it Necessary?
During a sellers' market, when the competition is fierce, there is no better time to pull out all the stops. An appraisal gap clause can make all the difference in making your offer stand out over the rest.
When you are faced with having to pay over the appraisal price, it's best that you remain in the driver's seat as much as possible. By proactively including an appraisal clause, you are setting the amount over the appraisal price you are willing to pay. Sellers look for the appraisal clause as reassurance that the sale of their home will go through.
Another option a buyer may consider, negotiate with the seller to split the cost of the appraisal cost. Agreeing as much as possible before signing a contract will save time, reduce stress, and avoid renegotiations.
With the current housing market being in favor of the seller, buyers are facing the reality of paying over the appraisal price to be the winning offer. No one sets out to pay more than what a property is worth, however, in the current market, it has become a common trend.
Buyers need to protect themselves before going into a contract and have a plan in place should the appraisal come back lower than the sale price. Ashford Realty Group will have their team of professionals guides you through this type of process to ensure you are protected and ultimately feel comfortable with the possible outcome.