If you’re actively shopping for a home, or you know people who are, you’re probably aware that many homes are going for well above the asking price right now. In a competitive real estate market like the Denver metro area, it’s becoming the norm for homes to receive multiple offers above the asking price. If the buyer is using a loan, they will often be required to get an appraisal. Appraisals use sold comparable homes (comps) up to six months in the past to determine the appraised value. Appraisals are a rearview mirror and in an appreciating market like ours, can come in low. This brings up a question for many buyers - what is an appraisal gap and how does it affect them?
What is an appraisal gap clause?
This is a clause in the real estate contract that states the buyer is willing to cover the difference between the sales price and appraisal. In a competitive offer situation, sellers will expect this from the buyer. It demonstrates to the sellers that the buyers are serious and removes risk to the seller.
What is an appraisal contingency?
An appraisal contingency is a clause that states that a buyer can walk away from the deal if the appraisal comes in low. While the buyer will still have to pay for the appraisal, they will be able to keep their earnest money if they terminate the contract.
What happens when an appraisal comes in lower than the sale price?
Loans are determined on appraised value. So, what happens if the appraisal comes in lower than the sales price? Buyers have a few options.
The buyer can talk to the seller about splitting the difference, but in a hot market, this can be a challenge. They could negotiate seller concessions to make up for the difference, but again, this can cause issues in the deal too. Another option is to dispute the appraisal with comparable sales in the area. It’s difficult to win an appraisal challenge, but not impossible. The buyer can also bring the difference and if they added the appraisal gap clause, they did commit in good faith to do so.
What should a buyer do in the event of an appraisal gap?
If the buyer is set on buying a home that appraises for lower than the sales price, it’s up to the buyer to cover the difference. This doesn’t have to be scary and is not a bad thing. Essentially the loan amount is now based on the appraised value which means the buyer is borrowing LESS!
Then the difference is made up in cash to close and their payment is reduced! The buyer can also adjust their down payment, for example from 10% to 5%, and use that additional money to cover the gap. Sometimes this doesn’t impact payment at all or can be slight.
Here’s an example… If the original purchase price is $400,000 and the plan was to put 10% down, the loan amount is $360,000 and the buyer brings $40,000. The appraisal comes in at $380,000. Now the loan amount with the 10% down is $342,000 and the buyer brings $58,000 with the price remaining at $400,000 - lowering their payment and increasing their equity position.
Another option is the buyer changes their down payment to 5% for a loan amount of $361,000 and simply brings what they were originally expecting: now $39,000. Payment remains the same and so does the cash to close! Once the home closes, this home now becomes the new comp for values in the neighborhood.
Looking for a knowledgeable real estate partner to help you through these situations? Get in touch with me at 8Z Real Estate! I have the experience and expertise to help you navigate situations like this one and Denver’s highly competitive real estate market.