All You Need to Know About the Appraisal Gap Clause

The appraisal gap refers to the difference between the appraised value of a home and the actual purchase price that is listed in the sales agreement. Today, more people are leveraging the opportunity to finance their home purchase. This is because mortgage interest rates are relatively lower as compared to the historical average. People who had trouble buying their own place earlier can do so now.

Whenever you are involved in the purchase of property, i.e. a house, apartment, condo, or penthouse, the mortgage lenders need an appraisal before they can proceed with the process. The appraisal involves a thorough and informed estimate of the property market value. It helps determine whether the required amount requested by the applicant is justified.

However, for the mortgage to go through, a purchase transaction has to be successfully executed. This involves a situation that is known as the appraisal gap, which is something that most buyers and sellers are unaware of. This article covers everything you need to know about the appraisal gap clause. It also touches on implications for the sales transaction that is due to take place.

What is an Appraisal in Real Estate?

An appraisal is an estimate of the market value of a property. Hired by the mortgage lender, a real estate appraiser performs this service. They process applications for home loans, purchase refinancing, and other types of loan instruments that they offer.

A purchase price is determined when a sales contract is drafted between a buyer and seller. The mortgage lender will lend money to the buyer for buying the home. They have the assumption that its value matches the appraised value. The appraisers are responsible for providing their input on how much a home should be worth.

The appraisal value protects the mortgage lending company from lending an amount that is higher than the actual value of the property. However, appraised values also have a margin for error. This means that there is almost always an appraisal gap between the two.

How Does a Real Estate Appraiser Determine the Property Value?

Real estate appraisers are well-versed and informed in estimating the current market value of a property. Not only do they appraise the value, but they also provide a detailed report to the mortgage lender.

For the estimation process, appraisers make use of “comparables.” These factor in the values of recently sold properties. By taking into account the various aspects of comparable properties, a value estimate can be calculated.

Once a certain property is subject to a mortgage contract and has passed the home inspection process, the mortgage lender will greenlight the appraisal. The appraiser will visit the property, examine it, and take photos as well. Then, they will compare the features and amenities of the property against similar properties that have been sold recently.

Next, the appraiser will generate the appraisal report and present it to the lending company. They have the responsibility to protect the bank from lending too much money, while also safeguarding the customer’s interests.

Most of the sales contracts contain an appraisal contingency. This safeguards both the buyer and lender. The contract will end if the appraised value doesn’t do justice to the home value.

For instance, if the appraised value of a home stands at $200,000 and the contract sales price comes up to $225,000, the mortgage lender may only agree to pay the appraised amount. The buyer will have to come up with the rest. Buyers and sellers should be aware of this scenario before entering into a sales contract.

What is the Appraisal Gap Clause and How Does it Work?

As already discussed, the appraisal gap is the difference between the appraised value and the amount reflected in the sales contract. To close the deal, such a problem must be resolved. Therefore, the appraisal gap clause comes into play.

The appraisal gap clause states that the buyer is liable to cover the appraisal gap. If we refer to our prior example, the appraisal gap is $25,000 and the buyer will have to arrange for this amount in order to close the deal. However, when adding an appraisal gap clause of $25,000 or more, the gap will be closed on its own.

In simpler terms, the appraisal gap clause assures the seller that the buyer will cover the gap between the appraised value and contract price. There are several states that enforce the appraisal gap clause. Colorado is one of them.

An appraisal gap clause is particularly helpful in a seller’s market, where there is a high demand for homes and inflated value. This often leads to bidding wars, which push the actual value further north.

Therefore, it becomes all the more difficult for appraisers to estimate the actual market value of a home. The appraisal gap clause helps them to minimize the risk on the seller’s part.

How Does the Sales Contract Included the Appraisal Gap?

There are several ways to add the appraisal gap clause to the sales contract. Your realtor will be able to help you with it. In the clause, the key factor is the value of the appraisal gap that needs to be guaranteed. You can’t run the risk of putting a high amount as the guarantee. You might not be able to cover it.

Therefore, you need to tell your realtor how much you will be able to cover, and put the amount as the appraisal gap guarantee. Here is an appraisal gap guarantee clause example that can be added to the sales contract: "In the event that the appraisal comes in lower than the accepted sales price, the buyer agrees to pay and the seller agrees to accept up to $15,000.00 above the appraised value, but not to exceed the accepted purchase price."

This should be sufficient to relay to the parties involved that the buyer will cover the determined amount. Keep in mind there are several different ways to put it into the contract.

Conclusion

This concludes our guide on the appraisal gap clause and how it protects buyers and sellers. In a nutshell, it prevents the deal from falling through. It also prevents the buyer from having to pay a much higher amount to cover the difference. Whenever you are looking to buy a home on a mortgage, make sure to discuss the terms of the appraisal gap clause with your realtor.