What Is Appraisal Gap Coverage?

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Home buyers that know what they want and are ready to act quickly should know what appraisal gap coverage is if they want to secure their dream home. Often, this means making an offer that is higher than the property’s purchase price and may even be more than the home’s appraised value.

What Is Appraisal Gap Coverage?

To get an offer accepted, home buyers may have to go over the asking price. But when offering above the asking price on a property, it may be more than what the bank appraises the home for.

For example, say a home is listed for $100,000 and goes under contract for a sale price of $110,000. However, the appraisal comes in at only $105,000. Your mortgage lender won’t cover the appraisal gap for you. In this scenario, the buyer would have to either fork over an additional $5,000 cash to make the deal happen, convince the seller to accept a new purchase price of $105,000 or walk away from the deal.

Sellers are afraid of the latter option, so if the appraisal comes in short, they like to see a guaranteed offer over the asking price. Sellers want to be sure that the buyer will come up with some money to cover the difference between the appraisal and the offer.

That is called appraisal gap coverage. It is insurance for the seller that the buyer pays an additional amount over the home’s appraised value if the appraisal comes in less than the agreed-upon purchase price.

To modify the previous example, let’s say the house is listed at $100,000. The buyer offers $110,000 with $1,000 in appraisal gap coverage, and the home appraises for $105,000. The appraisal gap coverage now kicks in, the buyer comes up with $1,000 cash, and the new purchase price is $106,000. The buyer has to pay the seller $1,000 in cash because the lender will not include the appraisal gap coverage in the home loan.

If a seller is looking at two equal offers and one offer has appraisal gap coverage, but the other offer doesn’t, they will accept the appraisal gap coverage offer. Plus, in this scenario, the buyer gets the house for less than they initially planned on purchasing it for, so it is a win-win!

When Is Appraisal Gap Coverage Necessary?

In a market where buyers outnumber sellers, offers can get crazy. This is a problem for a seller because they might take the best offer only to have the property appraisal back well under the sales price.

If this happens, the buyer and seller both have to agree on what the home price will be and/or who will pay for the difference between the offer price and the appraisal. So, a seller should include an appraisal gap guarantee clause in the contract so they can feel confident taking the highest offer even if they are worried the appraisal won’t support it.

Dealing With an Appraisal Gap

Appraisal gaps are common in a seller’s market, but there are a couple of ways to deal with this issue. Either the buyer or the seller can request a review of the appraisal. Look over the reasons the home appraisal came in lower and decide whether it is actually worth the sales price. Then the buyer and seller can decide between these two options:

Pay the difference

In really hot real estate markets, a buyer may decide that they want to pay cash for the difference between the appraisal and the purchase price. Of course, this means they’ll have to come up with the money on their own to pay this appraisal gap, but they may feel the home is worth it. They might also be willing to pay this difference when other homes are selling quickly, and they’re worried about missing out on the deal. 

Renegotiate

The other option for buyers and sellers is to renegotiate the real estate deal. If the appraisal gap is too large or the buyer can’t come up with the funds to cover the difference, it may be worthwhile for both parties to decide on a new purchase price. A seller has to decide how much less they’re willing to take to ensure their property isn’t leftover even in a hot housing market.

How Does Appraisal Gap Coverage Work With an Offer?

Appraisal gap coverage makes a buyer’s offer stronger in any market. That said, it is almost always used in a high-demand market, where the buyer needs to incentivize the seller to take their offer.

For example, let’s say a couple is considering buying a two-bedroom condo in downtown Denver listed for $385,000, with offers pouring in from all sides. They know they need to come in strong with a serious offer. They decide to put in an offer for $415,000 with an appraisal gap coverage of $5,000. Hypothetically, let’s say the place is appraised at $400,000.

An offer for $415,000 (without appraisal gap coverage) would mean that the lender would only secure the loan for $400,000. There is now a $15,000 difference between what the seller thought they could get and the loan. Now everyone is required to renegotiate. Will they split the $15,000? Will they lose the contract? No one wants this because buying or selling a house requires paperwork, so sellers really do not want to be in this position.

An offer for $415,000 on a house that appraises for $400,000 with $5,000 in appraisal gap coverage means that the buyer is securing appraisal plus $5,000. So, in this case, if the buyer offered $415,000 and it came back at $400,000, they are guaranteeing they will pay at least $405,000. The offer is stronger because the seller knows they will get the appraisal plus $5,000 even if the market doesn’t support this price.

A bank loan will not support this sales price, so the buyer needs to make sure they have the cash to cover it. If they offered $5,000 appraisal gap coverage and the appraiser says the property is worth less, the buyer has to come to the closing table with the $5,000 in cash.

This is a great tool to help an offer stand out in a competitive market, but it should not be confused with an appraisal contingency.

Appraisal Gap Coverage vs. Appraisal Contingency

An appraisal contingency clause in the real estate contract defines a condition or action that must be met for the sales contract to become binding. Both parties — the buyer and the seller — must agree to the terms and sign the sales contract, contingencies included, to make it binding.

These added clauses enable the investor to acquire property on their terms and provide a way out of the contract if things go south. However, since a real estate contract is binding, buyers must understand how they are used and how to remain competitive when making offers.

An appraisal contingency clause ensures that the purchase depends on the findings of an appraisal. Typically, the buyer is simply making sure the home is worth what the seller says it is or, hopefully, worth more.

The contingency basically says either:

• The appraisal on the property is at least as high as the purchase price. Otherwise, the buyer can back out of the deal; or
• If the appraisal on the property is lower than the purchase price, the buyer can ask the seller to drop the price, and if the seller refuses, the buyer can back out of the deal.

The appraisal contingency often goes hand in hand with the financing contingency, as the lender will not fund the loan above the appraised price.

One of the advantages of appraisal gap coverage is that it helps buyers stand out, and it also doubles as a safeguard from potentially overpaying for a property. Either way, it will help increase the likelihood of an offer being accepted and should always be considered when making a real estate purchase.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.