What Is an Appraisal Gap Clause?
Why Are Appraisal Gap Clauses Necessary in Real Estate?
Appraisal Gap Clause Example
What To Do When the Appraisal is Less Than the Offer?
Appraisal Gap Clause Bottom Line
An appraisal gap clause, also known as an appraisal guarantee clause, is a provision in a real estate purchase contract that commits the buyer to pay their original offer price even if the appraisal reveals a lower value.
This is because lenders won't issue a loan for more than what the home appraises for. After all, they will risk losing money if they have to short-sell it if the buyer defaults on the loan. So, an appraisal gap clause commits the buyer to paying the difference between their offer and the valuation – also known as an appraisal gap.
An appraisal gap clause comes into play if there is a bidding war and one buyer wants to sweeten their offer. It makes sense if you have your heart set on a particular property and have the cash to pay the difference. In most cases, without an appraisal gap clause, the buyer has the right to walk away from a sale if the appraisal comes in low. So, a seller may be hesitant to accept an offer that exceeds what they think the home may be worth. An appraisal gap clause signifies that the buyer is aware that their offer may be inflated, but they are willing to take the risk to secure the property.
Say your bank approves you for a $500,000 loan with a 10% down payment and a low-to-value ratio of 90%. Then you start looking at properties and come across your dream home at an open house. But someone else is ready to put in an offer of $470,000. So, to entice the seller, you make an offer of $500,000 with an appraisal gap clause.
The seller accepts your offer, but the appraisal reveals that the home is only worth $475,000. So, the lender will only be willing to give you up to 90% of the home value, which would be $427,500. When you add in your 10% down payment ($50,000), you'd only have $477,500. So, with the appraisal gap clause, you'd be expected to pay the additional $22,500 out of pocket.
- Pay the Difference
- Challenge the Appraisal
- Get a Second Opinion
- Cancel the Sale
1. Pay the Difference
The simplest option is to pay the difference and proceed with the sale. Any time you sign an appraisal gap clause, you should understand that there's a possibility you may be required to foot the bill. So, if you can't afford it, you shouldn't agree to include the clause. You can also set a limit on the appraisal gap, so you won't be expected to pay more than you can realistically afford.
Another option is to renegotiate with the seller. This may be tough to do if there is interest from other buyers, but it's worth a shot. You could try to get them to accept a price equal to the appraised value, eliminating the gap. Or you could convince them to meet you halfway to help reduce some of your financial burdens. They might be willing to renegotiate to save the deal if there isn't much attention from other buyers and they're looking to sell quickly.
3. Challenge the Appraisal
If you believe the appraisal may be inaccurate, you could challenge it. While appraisers are licensed professionals, that doesn't mean they're above making a mistake or displaying negligence in their work. So, if you have good reason to believe that the valuation isn't accurate, you can dispute it. But be prepared to show evidence to support your claims. You can't challenge an appraisal just because you don't like the results, so this is only an option if there is adequate evidence for reconsideration.
4. Get a Second Opinion
If your lender refuses to challenge the first appraisal, you could always try your luck with a new lender. They will send a different appraiser to evaluate the property, who may offer a more favorable opinion. Unfortunately, finding a new lender will be time-consuming, as you'll have to go through the pre-approval process all over again. Plus, there's no guarantee that the second appraisal will differ significantly from the first. But, if you feel confident that the first appraisal was inaccurate and your lender won't agree, you can always seek a second opinion.
5. Cancel the Sale
If all else fails, you may be able to back out of the sale. Most purchase contracts have an appraisal or financing contingency that allows you to back out if the appraisal is low. However, it gets more complicated if there is an appraisal gap clause. You should consult your broker and attorney before canceling the sale because you may have to forfeit your deposit, depending on what's stated in the contract.
When you make an offer on a home, there is always the chance that you're offering more than it's worth. So, before you submit an offer, you should work with your real estate agent to pull comps and determine a fair estimate. An appraisal gap clause can enhance your bid if you feel confident in your ability to cover any potential shortfall. But be sure to determine how much you're comfortable paying and don't agree to something you can't afford, or you could be stuck with a hefty bill at closing.