As a buyer, you’ve probably been learning about how much it costs to compete in a seller’s market. You understand the need to save for: a good-sized down payment, earnest money, closing costs, and enough left over for some home repairs. One of the more common costs for buyers in today’s market is one that may actually be unfamiliar to the buyer: the appraisal gap contingency.
What Is An Appraisal Gap?
First, let’s establish what an appraisal gap is before we discuss the contingency. An appraisal gap is the difference between the amount a home appraises for and an offer made by the hopeful buyer. For example, if you offer $870,000 on a home that only appraises for $860,000, you’ve got to make up the $10,000 appraisal gap difference in cash. Your lender will not loan you any more than what the home appraises for.
What Is An Appraisal Gap Contingency?
To become more competitive, buyers are including in their offers appraisal gap contingencies with certain amounts attached. A buyer may state in their contract that they are willing to automatically cover a $20,000 appraisal gap. If the house appraises for less than the offer, up to a $20,000 difference, the buyer is locked into paying the difference. Those with higher appraisal gap contingencies are considered the more competitive offers.
Many buyers are shuffling down payment funds to make these appraisal gap contingency amounts possible. Be wary of doing this, though. While you may obtain the home in a bidding war, if your down payment drops below a certain percentage, you could be stuck paying PMI (private mortgage insurance) for a long time.
Appraisal Gap Contingency vs Appraisal Contingency
An appraisal gap contingency is not to be confused with an appraisal contingency. These contingencies could be seen as opposite of one another. An appraisal contingency is when the buyer retains the option to back out of the contract if the property doesn’t appraise for the amount they offered to pay. The buyer is allowed to do this without losing their earnest money or facing other penalties. If a buyer removes an appraisal contingency to make their offer more competitive, an appraisal gap might result. It is then the choice of the buyer as to whether they follow through or back out and lose the money already invested.
Why Are These Gaps Happening?
Why aren’t homes appraising closer to the numbers people are willing to pay? The market has favored sellers for close to a year. There are many reasons, but contributing one factor is lenders and buyers are looking at the property very differently. What buyers will pay for a home in a market with low inventory may be starkly different from what it’s worth on paper.
With a lack of inventory, and hence sales, there also comes a lack of comps (short for comparables) necessary to help the appraiser make a more accurate calculation that reflects the current market. If nothing is for sale in a community, it’s difficult to make new comps with updated prices.
Additionally, some buyers are basing offer numbers on online listing estimates. These estimates don’t reflect how a professional appraiser calculates the value of a house. Zillow openly states their “Zestimate is based on a sophisticated and proprietary algorithm […] The Zestimate is not a replacement for an appraisal, CMA, or another home value estimator.” An appraiser is also looking at the home you bid on in particular. They evaluate the interior and exterior qualities of the home. This is something a market analysis can’t do in abstract, so something like a Zestimate won’t be as accurate.
Should You Use An Appraisal Gap Contingency?
It depends on your finances and the property. If you are in a market where costs will continue to rise and property values tend to be stable, this may be an option for you. This tactic could get your offer pushed to the top, but only use it if you have the cash on hand without putting yourself in a precarious place financially.
Before being swept up in a bidding war, ask yourself what is the maximum cash amount you’d be willing to pay for a property and make your contingency reflect that number. This is similar to deciding how much to place in an escalation clause, but remember, with this appraisal gap contingency, there is no possibility of a lender providing you with the necessary funds.
Let Us Help
It’s tough out there for buyers, but we know what to do to get you the loan you need to compete. We want to help you reach your goal of owning a home with our experience and resources. If you’d like to learn more, reach out to us at (877) 699-0353.