What is an appraisal gap? Everything you need to know

If you’re on the hunt for a new home, you already know: It’s tough out there. Low inventory over the last two years led to bidding wars and rapidly increasing home prices throughout the country. What’s more, even if you manage to outbid the competition and get your offer accepted, you could find yourself in an appraisal gap situation.

An appraisal gap happens when your lender’s appraisal value comes back lower than the purchase price you’ve offered. In these cases, you could be on the hook to make up the difference or walk away without your earnest money.

The good news is that understanding appraisal gaps can help you navigate this common scenario. Here’s what you need to know about appraisal gaps.

In a nutshell, an appraisal gap is the difference between the contracted purchase price and the appraised value.

For example, let’s say you offer $300,000 for a house. The seller accepts that amount, but then the house is appraised for $280,000. The $20,000 difference is an appraisal gap.

In a highly competitive real estate market, buyers might make an offer higher than the fair market value of a home. In some cases, the seller may have listed their home above fair market value and in other cases a buyer could have made an offer over the asking price. But just because a buyer is willing to pay a certain price doesn’t mean a lender is willing to structure a mortgage loan based on that amount. That’s why lenders require home appraisals.

Home appraisals are based on the condition of a property and comparable sales (or “comps”) in the area. Taken together, these determine the property’s fair market value.

Appraisals offer security to lenders by ensuring the property is worth the loan amount should the borrower default. A lender will typically only extend a loan for the appraised value, regardless of the listing price or the offer. This process can help protect borrowers from paying more than fair market value for a property, but in a tight market, appraisal gaps can become a source of frustration and feel like one more hurdle in snagging a home.

You can deal with a potential appraisal gap in a couple different ways: with an appraisal gap coverage clause or an appraisal contingency.

Most home purchase contracts include what’s known as an appraisal contingency, which releases a buyer from the contract in the event that the home appraises for less than the purchase price. A buyer may choose to waive the appraisal contingency to make an offer more competitive, especially in a hot real estate market. This is more typical for cash offers or a buyer who is willing to cover an appraisal gap out of pocket.

If you’re not ready to waive the appraisal contingency completely but you’re willing to cover up to a certain threshold, you can include an appraisal gap coverage clause (also known as an appraisal guarantee clause) in your contract. This clause simply states how much of an appraisal gap you’re willing to cover.

For example, let’s say you make an offer for $300,000 with an appraisal gap coverage clause for up to $20,000. If the appraisal comes back at $280,000, your contract is still in effect. But if it comes back at $275,000, you would be released from the contract without losing your earnest money deposit.

If you’re in the homebuying process and end up with an appraisal gap (the home has appraised for less than the contracted offer), here are a few steps you can take:

Prevention is the best medicine. If you haven’t made an offer yet, you can include an appraisal gap clause in your initial offer. It’s a good idea to include financial documentation and a mortgage pre-approval to prove you are prepared to cover a potential gap.

If you’re already under contract and end up with an appraisal gap, you can contact the seller and try to renegotiate the terms of sale. You could ask them to lower the purchase price or split the cost of covering the appraisal gap. Be aware, though, the seller is under no obligation to adjust the price based on the appraisal.

If you feel the appraiser has missed important details or otherwise undervalued the property, you can dispute the appraisal with your lender. You should be prepared with strong evidence to support your claim. Depending on the lender, you may even be able to order another appraisal from a different company, just be prepared to cover the additional cost. Take note: The new appraisal isn’t guaranteed to come back higher.

If you still want the property and you have the means, you can choose to pay the difference between the appraised amount and purchase price. This means that the lender only covers the appraised amount for your loan, and the rest will be added to your closing costs as part of a cash down payment.

If attempts to renegotiate don’t work and paying the difference isn’t feasible, you can choose to walk away from the sale — even if it means forfeiting your earnest money. Losing a few thousand dollars can be a better option than getting yourself into a long-term financial obligation you’re not prepared to meet.

When a home appraisal comes back higher than the offer price, you’re essentially paying below market value. (Congratulations on landing a deal!)

Keep in mind: When a home appraises for higher than what you agreed to pay, it doesn’t change the loan amount you qualify for — or the amount you’ll need for your down payment .

For the most part, sellers are obligated to follow through with a sale, even if the appraisal comes back higher than the purchase price. However, contracts can be customized to include any number of conditions. Be sure you understand the terms of the sale before you sign.

Appraisal gaps can be common when real estate is booming. Understanding your options can help you make the best homebuying decision in a hot housing market.