Appraisal gap: What home buyers need to know

An appraisal gap occurs when the appraised value of a home is lower than the purchase price. It also is a contract clause requiring the buyer to cover any appraisal gap and keep the sale on track. The appraisal is important when buying a home with a mortgage because a lender won't let you borrow more than the home is worth. If the home appraises for less than you agree to pay for it, you may be unable to borrow enough to complete the sale. Learn more about both definitions of the appraisal gap and your options if the home appraisal is lower than the purchase price.

What is an appraisal gap?

An appraisal gap occurs when the appraised fair market value of the home is less than the amount you’ve agreed to pay for the home. The appraisal is based on an unbiased, objective assessment of the property's condition and features, as well as market trends, including recent sale prices for nearby comparable homes.

Since your lender won't let you borrow more than a home is worth, a low appraisal can derail a sale. If you can't afford to cover the gap with cash or can't agree with the seller to reduce the price, you may have to walk away from the sale.

For example, if you’ve agreed to pay $450,000 for a home, putting down 10% and financing $405,000 with a mortgage. If the home appraises for $390,000, your lender won't let you borrow more than that, and you'll need an additional $15,000 to meet that price and close the deal.

Your options are to come up with an additional $15,000 for the down payment, negotiate a lower price with the seller, or exercise the mortgage contingency clause in your contract to cancel the sale and get your earnest money deposit back.

What’s an appraisal gap coverage clause?

An appraisal gap coverage clause, also called an appraisal guarantee clause, requires the buyer to fund the difference if the appraisal comes in lower than the accepted purchase price. Buyers could stipulate in the purchase and sale agreement a specific percentage or dollar amount they’re willing to pay if there is an appraisal gap.

This clause is common in a seller’s market, where buyers may need to submit more competitive offers to win a bidding war for a home.

How the home appraisal process works

Lenders require an appraisal when you're applying for a mortgage to buy a home. The appraisal is conducted by a licensed third-party professional, who will evaluate the home’s features, condition, and the local real estate market to estimate its fair market value.

The appraiser will usually conduct a thorough walk-through of the property and verify the home's key features, such as the number of bedrooms and bathrooms, the square footage, and the condition of the exterior. The appraiser will also research the neighborhood and review the sale prices of recently sold comparable homes.

You'll receive the appraisal report a few days or weeks after the inspection.

What do appraisers look at?

An appraiser focuses on the home’s condition and comparable sales, also known as comps, when determining a fair market value.

This professional usually will examine the home’s interior and exterior and evaluate the following features:

• Its age and overall condition
• Construction materials used on the home
• Any damage to the home
• Its location and amenities
• Number of bedrooms and bathrooms
• Any special features, such as whether it's a historical home or has a swimming pool
• Any improvements made to the home, like a new roof, energy-efficient windows, and new plumbing
• The size of the lot and the square footage of the home
• Any zoning restrictions

An appraiser will share publicly available data for similar homes in the area that have sold within the past six months or so. Comparable homes have features like those of the subject property to help the appraiser assess fair market value.

Most completed reports follow the Uniform Residential Appraisal Report (URAR) created by Fannie Mae. The report outlines the steps the appraiser took to complete their evaluation, including reviewing local market conditions for the home.

The beginning of the document will display the home's address and its appraised value. The remaining pages will show in detail how the appraiser arrived at the final appraised value.

Appraisal gap coverage vs. appraisal contingency

An appraisal contingency is a clause in your purchase and sale agreement allowing you to cancel the purchase and retain your earnest money deposit if there's an appraisal gap.

Say the purchase price is $500,000, and the home is appraised for $425,000. If your purchase contract featured an appraisal gap coverage, you're on the hook for the $75,000 difference. If your contract includes an appraisal contingency, you can cancel the sale if you're unwilling to cover the difference or if the seller won't renegotiate the price.

You can put both a coverage clause and an appraisal contingency in your purchase and sale agreement. The agreement could stipulate that you, the buyer, are willing to pay up to a certain amount of the difference between the purchase price and the appraised value. If the difference is higher than the specified amount, you have the right to legally back out of the deal.

What should you do when the appraisal is less than the offer?

When an appraisal comes in less than the purchase price, you have several options, including renegotiating the price, paying the difference, or walking away from the home sale altogether. Understanding which option is best for you means you’re not committing to a decision that could cost you more than you can afford or are willing to pay.

Renegotiate the offer

The seller may be willing to negotiate a lower purchase price with you. Ask your real estate agent to inquire with the seller about reducing the price to fair market value. Doing so will eliminate the appraisal gap, help you secure financing with your mortgage lender, and avoid having to cover the difference.

Consider carefully how much you want to buy the home, as there is a chance that the seller is unwilling to lower the purchase price. You could meet them halfway by offering to pay an amount higher than the appraised value.

In a seller’s market, you may have less room to negotiate. Purchase contracts that have a kick-out clause mean that the seller could accept another offer if they don’t like yours after you’ve removed your appraisal contingency.

Another option is to ask for seller concessions or credits. If you reduce your closing costs, you can put those funds toward increasing your down payment and covering the gap. However, concessions won’t change the appraised value, and lender limits may still apply.

Pay the difference

If you really want to buy the home, you can pay the difference out of pocket. Say the appraisal gap is $25,000 and the down payment is $10,000. You’ll need to come up with $35,000. This amount doesn’t include any additional closing costs that your lender may require.

These additional costs mean that your cash to close, or total amount of money you’ll need, will be much higher. Furthermore, paying the gap may mean you’re paying above appraised value, which can affect equity.

You do have several options, including tapping into your retirement accounts. You may also need to pay taxes on the amount you withdraw. Discuss the option with a financial professional before proceeding.

Your family may want to help by providing you with funds to cover the difference. If so, be sure to have them draft a gift letter so that the lender knows exactly where the funds originated.

Dispute the appraisal

You may be able to dispute the appraisal report if you disagree with the result and ask the appraiser to reassess the fair market value.

To request a reconsideration of value (ROV), you’ll need to show that the appraiser used inaccurate data. Some examples include using inappropriate comps or failing to account for valuable features or upgrades.

It could also be the case that you found a mistake in the report that could have led to an inaccurate appraisal.

Submit your dispute in writing and include why you’re disputing the appraisal and documentation to back it up.

Cancel the sale

If you have an appraisal contingency in your purchase and sale agreement, you can back out of the purchase. Perhaps the seller was unwilling to reduce the price, or you don't want to pay more for a home than it's worth.

While it may seem like you've wasted time going through the process, it may be better than making a purchase you can't realistically afford.

You can still back out of a house offer even if you don’t have an appraisal contingency. However, you may lose your earnest money. Though rare, a seller may pursue legal action, depending on the contract and state law. Consult a real estate agent or attorney to learn more.

When is an appraisal gap coverage clause necessary?

It may be worth considering appraisal gap coverage and waiving the appraisal contingency if you face a competitive seller’s market. The clause could help your purchase offer stand out.

The bottom line: Appraisal gaps are navigable with the right strategies

Part of successfully navigating the home-buying process is learning about potential roadblocks ahead of time. An appraisal gap is one of them. The reality is that the home you want to buy could be appraised for less than the purchase price. You want to know how you can protect your best interests if that happens. Talk with your agent and lender early about appraisal contingency language.

Getting started on your home buying journey? Get your mortgage approval process started today with Rocket Mortgage.