Does the phrase “appraisal gap” strike terror in your heart? Or leave you scratching your head? What about hearing tales of “appraisal guarantees” that are often needed when you’re a buyer in this seller’s market? If you’re a buyer or seller and you’re not spending every waking (and sleeping!) moment thinking about the real estate market, you may be confused about what these terms mean for you, and they may feel a little scary. Knowledge is power, so let’s talk about what an “appraisal gap” is and what an “appraisal guarantee” means for a buyer or a seller.
If you’ve watched any of my market update videos you’ve heard one thing reiterated and that is that we are in a historically strong sellers market. We have a lot of buyers competing for every home and that means that we nearly always have multiple offers and those offers are often for well over list price as buyers do whatever they can to beat the competition.
On the surface you may wonder “how can that be a problem”? if you’re paying with CASH it’s not a problem, you can pay any price you choose to pay for something as long as you can show that you have the funds available to do it. This is a big reason why cash buyers have an advantage right now, the price is the price and the seller doesn’t have to worry about the bank’s appraised value.
However 80+% of people are NOT cash buyers, they have to get a mortgage for their home purchase and as part of that loan the bank will hire an independent appraiser to look at the property and determine if it’s worth the amount they are loaning you for it. They don’t want to be stuck with worthless collateral to sell if you default on your loan. This evaluation of value is called an “appraisal”.
Sometimes your mortgage lender’s appraiser says the house IS worth less than you agreed to pay. This is known as an appraisal gap or a low appraisal.
I sometimes hear buyers with high loan approval amounts suggest that it might be a good strategy to buy a lower priced home and just throw a large amount of money at it because they can qualify for a loan of that size, but that still doesn’t eliminate the issues around homes appraising for the value of the loan. And really, appraisals exist for this very reason.
Options as a buyer
What are your options as the buyer if you’re worried that the appraisal will come in lower than what you have offered? after all – Sellers want to get the price you’ve offered in the contract whether or not the appraiser says it’s worth that amount as loan collateral.
The option that has been most successful with sellers is writing appraisal gap coverage or an appraisal guarantee into the contract for the purchase of the house. We are seeing this happen about 45% of the time now and it is getting to be more common as the market continues to be tight.
What this essentially means is that you will put a larger down payment on the home which bridges the gap between what you’ve offered and what the bank is willing to loan and preserves your ability to finance the purchase and close on the home.
A typical home purchase contract has an appraisal contingency: wording that says the buyer can call off the deal if the property appraises for lower than the buyer offered. But in hot real estate markets, where buyers outnumber sellers, some buyers waive the appraisal contingency. These buyers either pay cash for the home or gamble that they have money to pay the difference between the appraised value and the price, however much that may be.
rather than waiving the Appraisal contingency entirely, offering to cover the gap on a low appriasal is the middle path. You’re offering some amount that you will make up via a larger down payment.
Take the example of the $120,000 offer on the $100,000 home that has a $10,000 difference between the purchase price and the appraised value:
- If you had offered to cover an appraisal gap up to $10,000, you would proceed with the purchase, bringing that extra $10,000 as a larger down payment.
- If you had offered to cover an appraisal gap up to $5,000, you would be entitled to withdraw your offer and get your earnest money deposit back. That’s because the difference between the offered price and the appraised value is greater than the $5,000 appraisal gap coverage.
At this point, the seller may wish to negotiate with you to keep the transaction in tact and they may agree to lower the price by the remaining $5000.00 difference, or they may choose to go to the next buyer.
You’re more likely to succeed when offering appraisal gap coverage if you include proof of funds to do this as well.
If you’re lucky, you may not have to worry about appraisal at all. The bank may waive the required appraisal if they can see market conditions support it and that the buyer is bringing 20% or more as the down payment. This means that they look at the market data and determine that the property is likely worth the purchase price, but you will not know this until you’re closer to closing.
Things to think about
A couple of things to add as you consider whether or not to do this on your next purchase agreement:
Think about the home you’re buying, it’s condition, price, and location and what you’re willing to do to purchase that home. You want to be doing this for a home that will hold or appreciate in value.
Because of the market conditions, home prices nationally increased over 14% year over year. Median home prices in Minneapolis and the Twin cities went up 10.9% year over year according to the Minneapolis Area Association of Realtors.
Put that into perspective with your purchase.
If you are buying a home priced at $100,000 today and prices continue on their current path, that home would be valued at $111,000 a year from now.
If you’ve agreed to make up $5000, or $10,000 in low appraisal, the likelihood that you will be “whole” in a short period of time is there.
Another consideration is whether or not you will be able to afford a home in a year or two if this continues and if interest rates continue to rise.
So, it’s a math problem. Never been a big fan of math problems, but looking at it this way really adds some clarity and perspective.
Reach out with questions! I’m always happy to help.