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When you buy a house, the mortgage lender requires an appraisal. Sometimes the lender's appraiser says the property is worth less than you offered to pay. This is known as an appraisal gap or a low appraisal. An appraisal gap can complicate financing, cause delays or even result in the cancellation of the deal.
» MORE: How a home appraisal works
What happens when the appraisal is lower than the offer?
When facing an appraisal gap, you have the following options:
Pay the difference in cash between the appraised value and the amount of your offer.
Walk away, if you have an appraisal contingency in your purchase contract.
Renegotiate with the seller.
Request a review of the appraisal if you find inaccuracies.
Apply with another lender in hopes that it will hire an appraiser who values the property in your favor.
This article is mostly about that first option — paying the difference. The next option — walking away — is the least risky. Like a little black dress, it will forever remain in style.
The last three options for dealing with an appraisal gap can save money and preserve the deal, but might be impractical when home buyers outnumber sellers. This imbalance, called a seller's market, leaves home buyers with a weak negotiating posture. In some instances, the seller won't budge when asked to reduce the price to the appraised value. An impatient seller might reject a request to seek an appraisal review or to start over with a loan from another lender, because those approaches invite delays.
How to deal with an appraisal gap
Pay the difference in cash
Let's say the seller won't reduce the price. The seller sees it this way: You signed a contract to pay a certain amount, and other would-be buyers may be waiting to take your place if you can't or won't go through with the purchase.
If you're determined to buy the property, it’s going to take a bigger down payment than perhaps you had expected. How much more? Enough to cover the difference between the appraised value and the price.
Before laying out an example, let's take a one-paragraph detour to explain why this happens and how the appraiser fits in.
Mortgage lenders won’t let you borrow more than the home is worth. To confirm whether the property is worth what you offered, the lender hires an independent, third party to assess the property's value. The appraiser is that third party. To home buyers' chagrin, appraisers sometimes conclude that properties are worth less than the offer.
Cash buyers don't have lenders peering over their shoulders, so they don't need appraisals, says Chuck Vander Stelt, a real estate agent in Valparaiso, Indiana, and founder of quadwalls.com. The ability to buy without an appraisal gives cash buyers an advantage in a competitive market.
But most buyers need mortgages. The appraisal is important because the loan amount is based on the appraised value. If the property appraises for $100,000, and the loan requires a 5% down payment, then the maximum loan size will be 95% of the appraised value, or $95,000.
But what if you had made an offer for $110,000? The lender will advance you $95,000 based on the $100,000 appraisal. That's $15,000 less than the price, and you'll have to bring every penny of that amount to closing. This situation can be stressful if you expected to make a down payment of around $5,000, only to find out that you'll have to scrounge up another $10,000 because of the low appraisal.
Example of a low appraisal
Difference between price and loan amount:
Renegotiate with the seller
When the purchase contract has an appraisal contingency and the appraisal is low, you can try negotiating with the seller to reduce the price. You can ask the seller to cut the price to the appraised value or to split the difference.
Renegotiating with the seller is less likely to succeed when there were several competing offers. In such a case, the seller can tell you to take a hike and accept the next-best offer. Asking to renegotiate can be a risky request in a seller's market rife with competing offers.
Other ways to overcome an appraisal gap
You can request a review of the appraisal if you find inaccuracies in the appraiser's report. Your agent can help with the research and paperwork. Or you could apply for a mortgage with another lender and hope for a more favorable appraisal. The problem with these approaches is that they take time. An impatient seller might throw out your offer and accept another.
Lastly, if you have an appraisal contingency you can walk away and make an offer on another property. With luck, the appraiser won't think you're paying too much.
Limit your exposure with appraisal gap coverage
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.
There's an interim step you can take between having an appraisal contingency and waiving it: appraisal gap coverage. It sounds like some sort of insurance policy, but it's not. It's custom wording in the purchase contract that says you will pay the difference between the appraised value and the contract price, up to a certain amount.
Take the example above, with 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.
But if you had offered to cover an appraisal gap up to $7,500, you would be entitled to withdraw your offer and get your deposit back. That's because the difference between the offered price and the appraised value is greater than the $7,500 appraisal gap coverage.
Your offer needs to be believable, especially if there’s a bidding war on the property. You're more likely to succeed if you include financial documentation with the offer.
"Not only should you be turning in your preapproval letter, you should also be turning in a proof of funds demonstrating you've got those funds to cover that appraisal gap," Vander Stelt says. This will make your offer look more credible than competing offers without documentation.