What Is An Appraisal Gap? (5 Scenarios To Know!)

Certified Mortgage Advisor
NMLS 1701021
Published 
May 18, 2022

Appraisal Gaps and everything in between

You've likely heard of an appraisal gap and wondered, is this something that I should do should add to my contract, or maybe you've heard the term appraisal waiver and wondered how this is going to affect you. If you either have one or go up against other buyers who are using appraisal waivers or appraisal gap clauses.

So I'm going to explain, how it works. If you should use one and how does it impact kind of the whole home buying situation and market that we're in right now. 

What is appraisal?

Basically, let's talk about an appraisal first and appraisal is when a lender, needs to justify the value of the home that you're buying. So let's say we're looking at buying a home for $425,000. They're going to send an appraiser most of the time, they're going to send an appraiser out to see if the home is worth that. They need to justify that if they're going to give you a loan for close to $425,000 at the home is actually worth that. If you end up not paying back the loan and they need to sell it.

Short appraisal and how it kills the deal

So, what ends up happening is sometimes appraisals can come in low, and this is often referred to as a short appraisal. When that happens, it usually can kill the deal, because you said you were going to offer the seller 425, but then the lender won't give you money to be able to cover up to 425,000. If the appraised value comes in at let's say $415,000, that's a $10,000 sort.

Waiving the appraisal contingency

So what happens with an appraisal gap, or an appraisal gap clause. Sometimes people call it an appraisal waiver. It's not an appraisal waiver. We're not waiving the appraisal or waiving the appraisal contingency. So often in something like a purchase contract, there is a clause that states, if the home doesn't appraise that the buyer is able to back out of the contract. Meaning that if the home comes in at a lower appraised value, you don't have to continue moving forward buying the house that gives you protection as a buyer.

Incentive to the seller

Also, in a really competitive market, having an appraisal gap clause or what people would call an appraisal waiver. We're really just waiving the appraisal contingency. It's called different things and it's confusing. But what this does is it gives a little bit of incentive to the seller to say, oh, we might go with their offer instead because they're willing to pay extra money if the home doesn't appraise at the purchase price. And so in this, you're basically saying we'll pay extra money upfront on top of your down payment and closing costs to be able to move forward with this.

Scenario

So for instance, you might have a real estate contract that you offer. So when you give an offer to a seller, you find a house that you like and say, we want to offer $425,000, and then you might add a gap. And so for instance, you could add a $15,000 gap, or you could add a 10,001 or a 5,000. Basically what this means is if the home comes in, let's say $15,000 short in value, you're willing to bring $15,000 in cash to cover it. So for instance, on a $425,000 purchase price here, you'd be covering the difference if it came down to $410,000, okay.

What can make you offer stand out?

Now you might ask, how can I compete against something like this? If someone puts in an offer like this. You might be at the point where you're like, you know, the down payment closing costs are kind of really tight for us. So we don't really have extra money. And that is why people use these appraisal gap clauses because it helps their offer stand out amongst all the other offers. This is a way to make your offer more competitive. If you have the flexibility with cash.

Unfortunately, it does make home-buying more difficult for people who don't have the cash to be able to spend like this.

Example of a Residential Real Estate Purchase Agreement

So let's look at an example here. The clause that gets written is going to be different based on your location. All contracts are different locally. But this is just an example of what this could look like. It might be included in your contract, or it may need to be a separate addendum, with the contract. So it might say if the property does not appraise for the purchase price, the buyer agrees to pay up to $20,000 above the appraised value. Not to exceed the purchase price. So something that simple that basically says if the home value comes in 20,000 lower at the appraisal, you as the buyer, are willing to pay $20,000 at the closing table to make up the difference.

Solutions to a short appraisal

So let's talk about quickly the solutions to short appraisal because it's not just the appraisal gap that can help you with a short appraisal and shorter appraisals, unfortunately, are getting more and more common as home values are well, as people are offering more for homes and home values do increase.

People are offering more a lot of times than a home is worth in its appraised value. Okay. And they're putting in these appraisal gaps, so they might get a short appraisal coming in. Here are some solutions to fix this.

1. Ask the appraiser to reconsider

Number one is we can ask the appraiser to reconsider the value with new comparable homes. When you get an appraisal, the appraiser is often looking at three homes that have recently sold within the past six months and a half-mile radius. That is usually what they're looking at. Your realtors, either the buyer, your agent, or the seller's agent could submit a new comparable for the appraiser to use haven't seen this be super successful as a strategy.

2. Get a new appraisal

Another option is you could get a new appraisal. This only works on a conventional loan, but you could actually switch lenders and get a new appraisal with that lender. And you're kind of hoping that the value comes in. It could come in. So just keep that in mind.

3. Seller reduces price

Option three is for the seller to reduce the price. So, you know, back to our original example, if you offered 425 and it came in at 415, the seller could drop the price to 415, odds are, they probably don't want to do that.

4. Buyer pays the difference

The fourth option is you pay the difference. You bring cash to the closing table to pay the difference here. And this is what an appraisal gap clause is. It's building this number four solution into the contract before the appraisal happens. All these other solutions happen. If the appraisal comes in short. Option, number four is what people use. They kind of bake it into the contract to make their offer stick out.

5. Buyer and seller split the difference

Number five is splitting the difference. Some people do this 50/50, even you might do 60/40, 80/20, whatever the seller might come down a little bit. And you as the buyer might bring extra money to the table. One quick note here is you actually can use your down payment to help cover a short appraisal.

Down payment can help cover a short appraisal

So if you have a down payment that's higher than the minimum down payment, for instance, on a conventional loan, the minimum is 3% down. If you're putting 10% down, we have 7% of wiggle room there. Where you can bring your down payment down to the minimum and use that extra percentage to cover the short appraisal that sometimes can work. Sometimes you can also remove seller credits to help cover that difference as well.

So several different options. You can talk with your loan officer to explore these options too. And if you're looking for a helpful loan officer, you can click on this link: WTHYL - Lender.

Will lenders allow this?

Because I know this can be kind of confusing where it's like, why can't the lender just give me the money that I need? Lenders are going to look at the lesser of the purchase price or the appraised value. They're going to look at the two and see which one is the lower one. And they're going to use that as the actual value of the home.

Prove that you are worthy to cover the loan

Also, keep in mind the reason why they're doing this is if you know, the lenders are looking at risk. So if in the future, you don't pay on the loan anymore and they need to foreclose and sell the home. They want to make sure it's worth enough to cover the loan that they gave you. If they gave you a loan for up to 425,000, but it's only worth 415. Then they took a loss on that there. So they don't want that to happen. So they're gonna look at the lower of these two. So in this instance, they're going to look at the 415, if the appraised value is lower than the purchase price.

So then your down payment is going to be based on the lower value. So if you were initially putting 5% down and initially you were going to be putting 5% down on the purchase price, well, the appraised value came in lower. So 5% down is going to be based on the appraised value. So on a $415,000 appraised value, the down payment is $20,750.

So that sounds great. Well, our down payment went down. That's awesome. But we still have to make up this difference because we're under contract to purchase for 425, but the appraised value is only 415. So the lender's loan, plus our down payment equals 415. We can give that to the seller, but the seller still needs the 425.

And that's where we go back to the solutions that can help us resolve these here with the appraisal gap, it builds in this number four option to say we're going to cover that gap up to a certain amount if it comes in. So keep in mind, that this is going to cost money to put in an appraisal gap.

Option out of the contract should be normal

So a normal appraisal contingency gives you as the buyer an option out of the contract, where if you say, I want to buy the home for 425, but it appraises at 415. You can back out of the contract. That's what a normal appraisal contingency does. It protects you as the buyer. If the value is shorter or is lower than what you initially were going to offer for it.

So this is nice built-in protection to help you not overpay for your home. Most people need this protection. That's why it's baked into every contract that I've seen has this clause, this contingency is there to protect you as the buyer.

Appraisal gap guarantees the seller gets paid the purchase price

However, an appraisal gap overrides that protection and then guarantees the seller that it gets paid at the purchase price. And you know, this is like up to a specific amount, right? It's not an unlimited thing it's up to, and you can specify this $20,000, $25,000, $3,000, whatever gap you want to put in there. Obviously the bigger, the number, the more competitive your offer is.

Quick example

Using the numbers we've been using if we have a 425,000 purchase price. Let's say it appraises $10,000 short 415, our down payment is based on the 5% down, which is $20,750. Now that's not the end of the story. We also have to pay the gap. And let's say in this instance, we offered up to a $15,000 gap. But the difference is only $10,000. We're just going to have to bring the $10,000 to closing.

So at the closing table, you're going to be paying the down payment of 20,750. Any closing costs that you have as well. And the appraisal gap difference. That is only if you have that appraisal gap clause in your initial contract.

Make sure you financially ready

So just be extremely careful that if you do decide to go forward with this, you have the money to be able to do this. You have the flexibility to be able to do this, and you're comfortable spending that money. If you need to.

How to add a gap to your offer

So here's how to add this gap to your offer. If you want to set aside these funds before please do this before you make your offer and be comfortable with this decision. Knowing that if you offer a gap of $15,000, you could have to pay an extra $15,000 at closing.

Clutch Funds

My friend, Javier Vidana has a YouTube channel, which is fantastic, and you should go watch it and check it out. He calls his clutch funds and I just think it's a great word for it. Clutch funds are kind of these funds that you have that help sweeten your offer a little bit to make it more appealing to a seller, to choose your offer over other offers. And your agent can help you explore what you need here in the gap? And if you're looking for a helpful agent, here's the link: WTHYL - Agent if you'd like that.

Don't forget other expenses

Now keep in mind again, that you have the down payment, and you have closing costs. If you're offering a gap, make sure you're budgeting that too, but then don't forget things like your moving expenses and everything that's going to happen between now and you moving into a home, make sure that you're extremely comfortable with this here. Because the appraisal gap clause or this appraisal waiver has people tend to call it is not for everyone.

Side note

There are appraisal waivers were an appraisal. Doesn't have to happen on a home based on what the underwriting software says. For some reason, there's been this mix-up where everyone calls appraisal contingency waivers, appraisal waivers. And they're not the same thing. So just keep that in mind when people are saying appraisal waivers and appraisal is likely, still getting done. They're just waving the contingency, usually up to a specified amount.

Include the appraisal gap language

To add this to your offer, you're going to include the appraisal gap language in your purchase offer. Again, this may be included in your contract. There may be a line in there for that often. It's usually an addendum that your real estate agent is going to have to write and submit with your offer. So talk to your agent and please, please make sure you're certain about doing this. This is a great strategy. If you have the cash to be able to do this, most people need the protection of the appraisal contingency.

And at the same time that appraisal contingency protection can make your offer less attractive in a multiple offer situation where the home that you're looking at is getting multiple offers on it. Just please be careful. Talk with your agent. Work these numbers and say if we had to go, you know, think the plan, worst-case scenario. If we have to use all of that money make sure that you're comfortable with them.

Bidding wars and how to win it

So are they a good idea? Well, number one, obviously they can help you win a bidding war. If you're looking at a home and it's getting 10 offers on it. If the seller looks at your offer and they see, oh, great. If the appraisal comes in short, they're willing to pay an extra $10,000 to make sure that we have that protection. You're adding protection for the seller to make your offer more attractive. That is going to help you win bidding wars.

Protects you from short appraisal

Protects you as built-in protection right away from a short appraisal. What often happens if you don't have an appraisal gap, is if a shorter appraisal comes in it then is kind of your offer is up in the air. Not only can you back out, but the solution on what to do next is kind of up in the air and has to be dealt with. So it adds an extra layer of protection in the beginning.

You have to come up with extra cash

Obviously, the big downside is you have to come up with extra cash. You have to have the extra cash to be able to afford to do this in a way you're taking a risk on we might not have to use it at all. We might have to use some of it, or we might have to use all of it.

Risk being "under water"

And the big risk here is this risk of being underwater and your mortgage and being underwater is basically when the value of your home is less than what you paid for. So I made this quick little illustration here to show right here. This is what you, the purchase price that you would have paid. And this theoretically is the value and the value could go up. But when we're planning long-term, it's always helpful to look at both solutions planning for things to go up is always great because the numbers usually always work in our favor.

But if we plan for things to go down and we're comfortable with what that looks like or where we are mindful of what the negative options look like. It's a much better way to plan things in the future. So if that's the case, if you made this little gap payment here, keep in mind the value of your home.

Could trend downwards and that could bring you into more of a gap here. Now, what does that ultimately mean? Ultimately means it's going to be more difficult to sell your home in the future. If you sell your home in the future, you might need to bring money to a close, or you might get less money than you expected in the beginning.

That is a possibility that you want to be mindful of. Not a guarantee that the value is going to go down. There are plenty of people, especially in the past couple of years who have put appraisal gaps or they have paid over what a home is theoretically worth to an appraisal, and they have ended up making tens of thousands of dollars in equity and appreciation on their home. Just be mindful of what could happen.

Quick scenarios

Let's say we had a purchase price of 425 and we have a $5,000 appraisal gap. So owner runs through a couple of different scenarios with appraisals to show you how this works.

Ideal situation

Let's say that the appraisal comes in higher than the purchase price, and it comes in at $430,000. This is the ideal situation. Theoretically, you've got a $5,000 discount for the home. The appraisal is saying the home is worth 430 and you bought it for 425. You got a nice discount. You never had to bring more, extra money to the closing table.

If it comes in at the contract price

This is great, too. Nothing happens that gap of money is not being used at all. And a quick aside too, like when you put in an offer with an appraisal gap clause, you don't submit the money anywhere. That is just saying, if the appraisal comes in short, I'll bring extra money to the closing table. That money doesn't have to be held by anyone, or anything like that.

When appraisal comes in short

Now let's talk about these scenarios. If the appraisal comes in short, let's say it comes in at $422,500. If that's the case, then we have to use $2,500 of it. See how we're saying up to $5,000. If it comes in at 420, we have to use the full thing. We have to use the full $5,000. So basically we're using the lender's loan plus our down payment, plus the 5,000, taking all that. And that's what we give to the seller. And when I say we, I mean the title company is going to do that for you, but this is kind of more theoretical here.

You can always back out of the deal

If it comes in at 410, let's say it comes in super low, and it's beyond what you said you would cover in your appraisal gap. Then this is that contingency kicks in where you actually have that protection again. You said you'd only cover up to 5,000, but it came in a lot shorter than that. And if that's the case, you have the option to back out of the deal or circle back to the options to fix a low appraisal. Maybe we look at submitting new comparables. Maybe we look at getting a new appraisal, or we look at the other options we can use to solve the short appraisal here.

Now, if you want to dig more into how to fix a shorter appraisal, be mindful of what you could run into and what you need to do in the future. Look at this video right over here: My Appraisal Came In Lower Than The Purchase Price, Now What?

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