In highly competitive markets, many home buyers offer more than the list price to secure their dream home. The issue is, if they’re relying on a mortgage, lenders may balk at the price if the house doesn’t appraise at or above the offer mark. That situation is known as an appraisal gap, and it can wreak havoc on the sale. Fortunately, there is a solution: the gap contingency.
A gap contingency is essentially a safeguard, creating opportunities to keep the sale moving forward even if the offer exceeds the appraisal. Whether you’re a first-time homebuyer, planning to sell your home, or simply want to be informed before you purchase your next house, here’s what you need to know about gap contingencies.
Appraisal Gap Explained
If you’re wondering, “What is an appraisal gap,” an appraisal gap is a situation where a buyer’s offer on a property exceeds its appraised value. For example, if a buyer is willing to purchase a home for $450,000, but an appraiser says the house is only worth $425,000, there’s an appraisal gap of $25,000.
Any difference where the appraised value is lower creates an appraisal gap. Whether the difference is $5, $5,000, $50,000, or more, it’s the disparity that defines the situation.
Offers vs. Appraisals: What Happens When They Don’t Add Up?
Home appraisals are a common part of the real estate purchase process. They allow a buyer to confirm that a property is worth at least as much as they’re willing to pay, ensuring they aren’t overpaying for a home simply because they weren’t aware.
With cash sales (or those where homebuyers make larger than required deposits), differences between the offer and appraisal aren’t inherently dealbreakers. Since they are using cash to cover all or a significant portion of the purpose, they can decide to move forward without disrupting any financing. However, if the offer exceeds the appraisal and a mortgage plays a major role in the purchase, the lender may refuse to finance the purchase.
Ultimately, appraisals are a safeguard for mortgage lenders, ensuring they aren’t offering a buyer a loan that’s larger than the property’s value. That way, if the buyer defaults, the house’s value can cover the remaining loan amount, allowing the lender to recoup its funds from a subsequent sale.
If the offer exceeds the appraisal, that protection isn’t there. As a result, the lender typically refuses to fund that loan. This may mean the buyer and seller either have to walk away from the deal or return to the negotiating table, neither of which may be ideal. In some cases, the buyer might try to contest the appraisal or turn to another lender, potentially allowing them to secure a new appraisal that may turn out in their favor.
However, with a gap contingency, the resulting challenges can be avoidable.
What Is a Gap Contingency?
A gap contingency is a clause in an offer outlining what the buyer is willing or able to do if their offer exceeds the property’s appraised value. Essentially, the appraisal gap guarantee clause is a promise from the buyer to the seller. It’s a form of reassurance, letting the seller know that the buyer has a plan if such an issue arises.
Within the gap contingency, the buyer outlines the maximum amount over the appraised value they’re willing to cover through other means. This could include making a larger cash deposit, getting an appraisal gap loan, or other mechanisms beyond the mortgage they were using to cover the purchase. They can address the difference by using alternative means, allowing their lender to safely approve their mortgage and ensuring the sale moves forward.
If you’re wondering, “What is an appraisal guarantee?” and appraisal guarantee is just another term to describe a gap contingency. Similarly, it can be known as an appraisal-gap guarantee, appraisal gap clause, or by similar names. Ultimately, they’re all describing the same mechanism in an offer.
Why Appraisals May Come Out Below the Offer
Currently, many housing markets are seeing prices rise incredibly quickly. As a result, many buyers have to make higher offers to remain competitive. However, even though the market suggests that the increased price may be reasonable in that area, that doesn’t mean appraisers will view the situation similarly.
Appraisers use specific calculations to estimate the fair market value of a home. Usually, this involves evaluating a house’s condition and features, comparing it to recent comps, and determining how much the property should theoretically sell for based on that data.
While the process is often reasonably accurate, it isn’t perfect. If there aren’t many actual comps in the immediate vicinity, the appraiser may have to make comparisons using properties with distinct differences or that sold well before the offer in question was initiated. In either case, determining fair market value becomes more challenging, and the appraiser may not see eye-to-eye with the buyer or seller.
Additionally, some buyers make offers based on emotions. They may feel that the house is their dream home, leading them to make higher offers to ensure they are the winning bid. In highly competitive markets, buyers might go the extra mile to ensure they catch the seller’s attention, also with the goal of getting to move forward with the purchase. In either case, they may overshoot the home’s value significantly, increasing the odds of an appraisal gap.
However, there are also times when the appraiser notices issues that the buyer and seller overlook. In this case, the assessment is fair; it’s simply their professional knowledge that lets them spot problems impacting the value that others would likely miss. As a result, their know-how leads to the appraisal gap.
Appraisal Gap Guarantee Example
Appraisal-gap guarantee verbiage can vary depending on the buyer’s goals and capabilities. Usually, the appraisal-gap coverage wording outlines the conditions where a buyer is willing to make up the difference between the offer and appraisal, including how much above the appraised value they’ll handle.
Generally, the buyer’s real estate agent will handle the verbiage, ensuring it accurately reflects what the buyer is willing and able to do. However, it’s helpful to know what one may look like, allowing buyers and sellers to know what to expect if one appears in an offer.
Here is an appraisal gap guarantee clause example:
If the property appraises for below the purchase price outlined in the offer, the buyer agrees to pay up to $10,000 above the appraised value, but not to exceed the offered purchase price.
The appraisal-gap addendum example above is relatively simple, but so is the average gap contingency. Overall, they simply need to outline the buyer’s commitment, ensuring the seller knows what will occur if there’s a gap. However, they can be more complex if necessary, too.
How Appraisal-Gap Guarantees Make Offers Stronger
If you’re in a highly competitive market or simply want to increase your odds of landing your dream home, having an appraisal-gap guarantee clause is a smart move. You’re giving the seller reassurances. Even if the appraisal ultimately may come out below the offer price, the fact that you had a plan in place is enticing, letting the seller know that the purchase can go forward even if the appraisal is a bit lower than expected.
For sellers, choosing an offer with a gap contingency (that’s also otherwise competitive) can decrease the odds of a sale falling through after an appraisal. As a result, it may help you sell your home faster, all while ensuring you get a fair price.
