Used When Appraisal May Come in Lower than the Purchase Price

An appraisal is a valuation of property by the estimate of an authorized person. When buying a home, lenders require an appraisal before issuing a mortgage because they want to protect their investment. If a property is being purchased for $200,000, the lender wants to know that the property is indeed worth $200,000. If the appraised value is lower than the purchase price, then the lender will not finance a mortgage loan for the purchase price. There is an appraisal gap that needs to be addressed.

The appraisal gap is the difference between the purchase price and the appraised value. For example, if the purchase price is $200,000 and the appraised value is $190,000, then the appraisal gap is the $10,000 difference ($200,000 minus $190,000).

Appraisal gap coverage is sort of like insurance for a seller. As part of a purchase offer, the buyer promises that should there be a low appraisal the deal can still move forward. The buyer does this by offering to pay the difference between the purchase price and a low appraisal in cash, typically up to a certain dollar amount.

Appraisal gap coverage is common in a seller’s market, when buyers are making offers above asking prices. A buyer’s agent may write appraisal gap coverage into a contract to make the offer stronger. A seller’s agent may request appraisal gap coverage from the buyer to insure against a low appraisal.

How appraisal gap coverage works

The asking price on a home is $190,000 and the buyer offers $200,000. The buyer might include an appraisal gap guarantee that covers the $10,000 over the asking price. If the home appraises for $200,000 or higher, there is no appraisal gap and the coverage is not needed. If the home appraises for $195,000, the buyer will need to bring $5,000 cash ($195,000 + $5,000 = $200,000) to closing to cover the gap. If the home appraises for $190,000, the buyer will need to bring the full $10,000 in cash to closing to cover the gap.

Let’s say this same buyer offers $5,000 in appraisal gap coverage. Again, if the home appraises for $200,000 or higher, there is no appraisal gap and the coverage is not needed. If the home appraises for $195,000, the buyer will need to bring the full $5,000 cash ($195,000 + $5,000 = $200,000) to closing to cover the gap. If the home appraises for $190,000, the gap is $10,000 and the buyer has only agreed to cover $5,000. This will send the deal back to negotiations and either the seller will have to reduce the sale price to $195,000, or a new price will be agreed upon by both the buyer and seller.

Importance in multiple offer situations

Appraisal gap coverage is most important during multiple offer situations. A bid over asking price may look strong on paper, but worry about a low appraisal will leave seller’s with no guarantee they will receive the offered amount. Appraisal gap coverage is that guarantee.

Buyers should prove they can cover the gap

Adding appraisal gap coverage to an offer can significantly increase the amount of funds needed to close. A buyer who offers appraisal gap coverage should also present proof of additional funds to cover the amount of that promise. That proof is sent along with the offer to purchase the property.

Buyers are not promising to pay more than they offer

Appraisal gap coverage does NOT mean a buyer will pay more than what they offer for a property. It is simply a promise that if the lender will not issue a mortgage loan at the purchase price, then all or a portion of the appraisal gap will be paid in cash to supplement the mortgage loan.

Cash buyers

At this point it should be clear why cash buyers tend to be heavily favored by sellers. A cash offer usually waives any appraisal contingency and once accepted, can close in as little at 7 to 10 days.