This article defines the appraisal gap and outlines possible solutions for the home buyer to discuss with their realtor and loan officer before submitting an offer. Being prepared in the event of an appraisal gap puts the borrower in the best position to get an accepted offer or successfully close the purchase if a shortage arises.
by Christian Scully
I've found that the most helpful topics to discuss on BL+F are questions that I am often asked by either borrowers or realtors. Appraisal gaps have always been an issue, but their instances have exploded in the past couple years. Home values have grown massively nationwide. Buyers are often paying in cash above asking price and waiving all contingencies. This sets the stage for a home selling for greater than a licensed appraiser can value the property. The difference between the selling price of a home and its appraised value is called an appraisal gap or an appraisal shortage.
For example if a home sells for $250,000 and the appraiser values the home at $225,000 - there is a $25,000 appraisal gap. A typical purchase and sale agreement would state that the contract is contingent upon the home appraising for at least $250,000. When the buyer applies for a mortgage it will be based on the sale price of $250,000, which combined with their down payment will dictate their loan-to-value ratio. A conditional approval from the lender based on these terms would state that the loan approval is subject to the appraisal of the property at or above $250,000.
There are five important options for a buyer and their realtor to know about preparing for and solving an appraisal gap. The chosen path completely depends on the buyer's goals and finances.
1. The seller can agree to lower the sale price to match the appraised value.
This is obviously the best option for the buyer. It saves the buyer money; it saves the seller from having to terminate the sale and start all over with another buyer. If the seller is in a hurry to sell then this might just work. However, as is often the case in today's market, if the seller received many offers, there may be other buyers ready to jump at the opportunity.
2. The buyer can terminate the purchase and sale agreement.
If the buyer has no additional funds to cover the appraisal gap out-of-pocket, if they are putting less than 5-10% down, or if they simply don't want to purchase the home after seeing the appraisal - they have the option to terminate the contract and recoup their earnest money deposit funds provided they did not waive their financing contingency.
3. The seller and buyer can negotiate a new sale price somewhere in between the appraised value and the original sale price.
If the seller has some flexibility and the buyer has access to some additional funds, it may be possible to find a middle ground that works for both parties. If the seller is open to it, usually it comes down to how much extra the buyer can come up with.
4. The buyer can pay the appraisal gap out-of-pocket.
If the buyer has enough extra funds they are able to access, and the seller has no flexibility regardless of the appraised value, and the buyer still really wants the house, they are able to pay the shortage in addition to their original down payment amount. This maintains the loan-to-value at the original ratio, keeping the terms of the conditional approval in tact.
5. The borrower can discuss with their loan officer using mortgage insurance to solve the appraisal gap.
This option is less known but is a fantastic strategy for buyers in the right scenario. The buyer can discuss this option with their loan officer to see if it fits. This is an example where having an educated and dedicated loan officer can be a valuable asset, as many realtors don't know or don't understand this option. For conventional loans where the borrower is putting down 5%-20%, it may be possible to either add or increase existing mortgage insurance to cover the appraisal gap.
This strategy is simply adjusting the loan-to-value and adding mortgage insurance. If a borrower already has PMI as part of their loan due to paying less than 20% down payment, then the amount of PMI could just be increased. Borrowers can also pay their mortgage insurance as a lump sum which would keep their monthly payment the same as on their Loan Estimate.
For example, if the purchase price is $250,000 and the borrower is putting down $50,000 - the loan amount is $200,000 or 80% LTV (loan-to-value). The borrower would not be paying mortgage insurance at 20% LTV.
If the home appraises at $225,000 - then the new LTV would be about 89%. So they can keep the same loan amount of $200,000, still put down $50,000 to get to the total purchase price, but now since they are at 89% LTV they will be paying mortgage insurance. The borrower can choose to pay that as a single premium at closing or potentially finance a single premium into their loan amount. By paying the mortgage insurance in a lump sum they avoid the monthly PMI cost, thus keeping their monthly payment unchanged.
+ Better Tip
Discuss these options with both your realtor and your loan officer. Having a plan of attack in the event of an appraisal gap makes everything so much easier. It can also really strengthen your offer if a seller knows that you are prepared for all scenarios.
Borrowers using online, discount or tech heavy streamlined mortgage companies shouldn't be surprised to find that the service level can be quite lacking. I have tried those lenders in the past and the "loan officers" were quite honestly terrible. Tech focused lenders can work great if there are no surprises or problems to solve, but as soon as an issue arises there is a good chance they won't know how to solve it. And news flash: problems come up! The mortgage process and real estate transactions are complicated behind the scenes. You want a loan officer that can guide you through solutions, be in contact with your realtor and attorney and get the job done.
Real Estate +
Thoughts, ideas, lessons-learned, inspiration, how-tos and more from a journey to own and invest in real estate, and helping borrowers navigate the mortgage process as a licensed loan originator.
Christian Scully is a licensed mortgage loan originator (NMLS 1864693) in Rhode Island, Massachusetts, Maine and Connecticut and is available to help borrowers seeking to purchase or refinance a home.
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Disclaimer: The creators of Better Life and Finance are not certified financial advisors and are not attempting to give general financial advice. The information is from personal experience and shared freely. Consult a professional financial advisor when making financial decisions. Christian Scully is a licensed mortgage loan originator and is qualified to answer your home loan questions.