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How Does an Appraisal Gap Coverage Clause Work

By Bill Gassett | March 22, 2022

The Appraisal Gap Coverage Guarantee Explained

In the current real estate market, many property buyers choose to finance their purchases. This is due to the low mortgage interest rates that have been that way for quite a while. However, with the current market heavily favoring sellers, quite a few buyers who would otherwise be taking out a mortgage are paying cash.

These buyers are doing so to make their offer far more enticing to home sellers. When you have a cash buyer, there is no worry about a buyer procuring financing and going through the appraisal process.

When bidding wars push prices well in excess of the home's asking price, it is not unusual to have appraisal problems. There is one way that has caught on to make the seller feel more confident the appraisal will not screw up the sale.

It's called appraisal gap coverage or appraisal gap guarantee. Maximum Real Estate Exposure has an excellent article explaining appraisal gaps.

A buyer will add language to their offer stating that if the appraisal comes in lower than the purchase price, they will agree to make up the difference in the form of a higher down payment. Doing so will satisfy the lender and allow the sale to proceed. The clause gives the seller confidence that there won't be an appraisal issue.

Let's take a look at everything you need to know.

Appraisal gap coverage clause.
Offering Appraisal Gap Coverage Can Increase Your Odds of Having The Winning Offer.

How Does the Appraisal Work

Nearly all lenders will request an appraisal during the mortgage loan process. The appraisal will be waived if the buyer puts down a significant amount of money.

The appraisal is an estimated value of the property’s value on the market. There is a whole system that allows an objective assessment of each property. The appraisal is conducted by a third party to ensure the appraisal amount is unbiased and accurate.

The Appraisal Gap Explained

How is the value of a home or a piece of land determined? Usually, several factors are taken into account, the location, the size, the condition it is in, other historical comparable prices, and many other elements.

The current state of the real estate market has been skewed toward sellers for the last few years. The days on market for homes have been minimal.

The pandemic, however, further exacerbated the lack of housing supply, putting a further strain on the market. It's been good news for sellers but a dreadful situation for buyers. A significant number of buyers are placing offers but losing out.

Once they move to the next house with the same amount of competition, they are forced to make their bid even stronger. Doing so has often resulted in a final purchase price considerably higher than the appraised value.

What is An Example of an Appraisal Gap

Let’s see an example for a clear understanding. You purchase a house for $500,000, where you plan on putting 20 percent down for a mortgage of $400,000. Now let's assume that the appraisal comes in at $480,000. There is a gap of $20,000 between what the appraiser says the home is worth and what you have agreed to pay.

The lender will be willing to lend 80 percent of the appraised value, which would equal $384,000. There is a shortfall of 16,000 in this circumstance. $400,000 vs. $384,000. To make up for the difference in the agreed-upon purchase price, the buyer would need to increase their down payment by $16,000 to bridge the gap.

When is the Appraisal Relevant?

The big attraction for sellers accepting an offer from a cash buyer is not wasting their time with an appraisal. Of course, if there are no issues with the appraisal, then the transaction will proceed to the next step with no issue.

By offering the appraisal gap coverage clause upfront, the seller can feel more confident there will be no appraisal hiccups. They can feel confident having their real estate agent put the property under agreement with fewer worries.

Besides Appraisal Gap Coverage, What Else Can Salvage a Home Sale

What happens when a house doesn't appraise, and you haven't offered to cover an appraisal gap as a buyer? There are a few options to work out a successful transaction. They are as follows:

  • Renegotiate a lower sale price that falls in line with the bank appraisal.
  • You can use the mortgage contingency clause to escape the sale due to the lender rejecting the financing due to a low appraisal.
  • Challenge the real estate appraisal if you feel it came in too low.
  • Get your financing done at another lending institution in the hope a different appraiser comes up with a higher value.

Final Thoughts

It should be clear that an appraisal gap coverage clause is not insurance. It merely states that a buyer is willing to cover the potential difference between the sale price and appraised price if one exists.

The clause represents an extra safety measure for the seller, who is protected against a failed deal due to the appraisal. The buyer also has an advantage because their offer becomes more attractive. It is possible that you can also put a cap on the amount of gap coverage you're willing to offer.

For example, maybe you would only be interested in covering up to a $25,000 discrepancy in the purchase price vs. appraisal amount. Of course, any limits you start to put on your appraisal gap coverage will make your offer less attractive.

All of your options would be discussed upfront with your real estate agent. Hopefully, you now have a much better understanding of how appraisal gaps work in real estate.

Bill Gassett is an authority in the real estate industry with 38 years of experience. Bill is well respected for his informative articles for buyers, sellers, and fellow real estate agents to make sound decisions. His work has been featured on RIS Media, the National Association of Realtors, Inman News, Newsbreak, Credit Sesame, Realty Biz News, and his own authoritative resource, Maximum Real Estate Exposure. He has been on of the top RE/MAX agents in New England over the last two decades.
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