What is an appraisal gap, and is it a deal breaker?

When buying or selling a home, there are two figures that matter most: the agreed-upon purchase price and the appraised value of the home. Sometimes these figures don’t line up, and that can cause problems when it comes time to finalize the sale. No seller wants to sell their home for significantly less than it is worth, and no lender will offer a buyer a mortgage amount that is more than the home is worth.

So what does it mean when these two prices are significantly different than expected, and how can it affect the sale of the home? Here’s everything you need to know about the appraisal gap.

What is an appraisal gap?

When a home’s sale price is higher than its appraised price, it creates what’s called an appraisal gap. Simply put, the gap is the difference between the agreed upon purchase price and the price that the home is determined to be worth, as assessed by a licensed professional appraiser.

“The purchase price is what a buyer and seller feel the home is worth, while an appraisal tells you what the value is, based on other homes that have sold that are similar,” explains Esther Phillips, senior vice president and director of sales at Key Mortgage Services in Naperville, Illinois. “All standard mortgage loans use the appraised value to substantiate the loan.”

Here’s a quick example to help illustrate how the appraisal gap works. Let’s say you are a buyer interested in a home whose asking price is $350,000. You make an offer for the full amount and the seller accepts. But when your lender’s appraiser assesses the home, they determine that the actual value is only $310,000. The result is an appraisal gap of $40,000, meaning you are asking your mortgage servicer to lend you $40,000 more than the appraised value of the home. That gap will need to be bridged somehow for the sale to go forward.

How to deal with an appraisal gap

An appraisal gap can certainly disrupt the sale process, and in some cases it can send both buyer and seller back to the drawing board. But it does not necessarily tank the sale. In fact, there are a number of different ways buyers can handle an appraisal gap that will allow the sale to go through:

Pay the difference

The most straightforward way to address an appraisal gap is for the buyer to pay the difference. This is not always an option financially, of course — some methods of payment are more realistic than others. If you have the funds available, you can simply pay the difference in cash. Or, if you are comfortable with it, you may be able to cash out some investments or access retirement funds without penalty in order to pay the difference. You may even be able to take out a separate loan to cover the amount.

In addition, you might be able to show your lender that you can afford the higher-than-expected monthly payments on the mortgage. Or they may allow you to make a smaller down payment, if doing so allows you to afford the higher monthly payments. Under this scenario, Phillips notes, you may have to get private mortgage insurance, which provides additional protection to the lender in case you are unable to make your payments.

Renegotiate

Another option that may be available to buyers who run into an appraisal gap is renegotiating the purchase price of the home. This option is especially relevant if you have an appraisal contingency in the contract (more on that in a moment).

You can ask the seller to lower the price to match the appraisal price — which they may be motivated to do, depending on their timeline and investment in the property. You can also ask them to split the difference or meet somewhere in the middle, shrinking the gap to an acceptable level that you can afford.

Get new financing and a new appraisal

It is possible to dispute an appraisal, though you will need significant evidence to prove that the assessed value is incorrect, including showing the appraiser failed to properly assess the market and misvalued the property.

With a successful dispute, you can seek new financing and get a new appraisal. This may provide an assessment that is more in line with the sale price — though there is no guarantee of that. This process is time-consuming and may not be something that the seller is willing to go through, especially if they believe other offers are available to them.

Appraisal gap coverage, contingencies and clauses

While appraisal gaps can interrupt the process of selling or buying a home, they are not unusually rare. In fact, most real estate contracts include some form of appraisal gap coverage that addresses the possibility of this exact scenario.

“Appraisal gap coverage is an interim step you can take between having an appraisal contingency and waiving it,” says Phillips. “An appraisal gap coverage clause is 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.”

While appraisal gap coverage ties a buyer to the purchase even if there is an appraisal gap, appraisal gap clauses, including a contingency clause, provide protection for the buyer. Some clauses may allow the buyer to back out altogether.

Phillips notes that appraisal gap clauses often include specific dollar amounts, which state just how much a buyer may be on the hook for, depending on the size of the gap. An appraisal gap contingency provides a legal way to get out of a sale contract, including recovering earnest money. Without this contingency, you may have to negotiate to cancel the contract and allow the seller to keep some of the earnest money that you paid.

Bottom line

Appraisal gaps can cause trouble when it comes to finalizing the sale of a home, because they suggest that the actual value of the property is less than the agreed-upon sale price. However, these gaps are relatively common. With a little preparation in the sale contract, both parties can protect themselves. In most cases, an appraisal gap does not need to be a deal breaker.