What is an Appraisal Gap Clause and How Does It Work?

Posted by Andrew Fortune 26,685 Views

What is an Appraisal Gap?

An "appraisal gap" is the difference between the appraised value of a home and the purchase price in the sales contract. An "appraisal gap clause" is used in a sales contract to guarantee that the home buyer will cover the monetary gap between the appraisal and the sales contract if an appraisal gap becomes an issue. We'll explain how this works below.

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This infographic explains an appraisal gap:

Example of an Appraisal Gap

To fully understand an appraisal gap, we must discuss the appraisal basics.

What is an appraisal in real estate?

An appraisal is an opinion of value by a licensed real estate appraiser. Mortgage lenders hire appraisers for home purchase loans, refinancing, HELOC loans, and many other loan products.

Every sales contract between a buyer and a seller has a purchase price. The bank agrees to lend money to the buyer to purchase the home, assuming the property appraises at value.

Banks hire licensed appraisers to offer their professional opinion on what the home is worth. This process safeguards the mortgage company from lending too much money for an asset that may not be worth the contract price.

Since appraisals are opinions, they have a margin for error. You may hire three appraisers for the same property and receive three different value estimates.

How Does a Real Estate Appraiser Determine Value?

How Does A Real Estate Appraiser Determine ValueA real estate appraiser is an expert in determining the current market value of a property. They provide a detailed report explaining their estimate when they conduct an appraisal.

Appraisers use recently sold properties (Realtors call them "comps" or "comparables") to determine a home's values. They break down aspects of each comparable sold property and use that data to calculate an estimate of value.

Once a home is under contract and has passed the home inspection process, the mortgage lender will order an appraisal. The assigned appraiser will then visit the property for a visual inspection and take photos of the home. Next, they will compare amenities and assets against recently sold properties within the same neighborhood and then prepare an appraisal report.

In a hyperinflated real estate market, appraisers are challenged to justify some crazy sales contracts that are listing agents present. They have to protect the bank from over-lending while protecting consumers from having their deals fall apart.

This tension is one of the most complex parts of the real estate transaction. Appraisers are responsible for helping lenders determine safe loan limits. This is a difficult task during extreme markets. 

What is An Appraisal Contingency?

Most real estate sales contracts will have an "appraisal contingency" written into the details. This clause allows the buyer and lender to avoid the contract if the home does not appraise at value.

In the example at the top of this post, the home appraised for $20k less than the contract sales price. The lending company may only lend up to the appraised value in that scenario. This means the buyer or seller must provide the money to fill the gap.

When a home does not appraise at the contract sales price, it can cause a deal to fall apart. This is a scenario that buyers and sellers have to understand before entering into a contract.

How Does An Appraisal Gap Guarantee Clause Work?

How Does An Appraisal Gap Clause Work?When a home does not appraise at value, the gap between the appraised value and the contract price must be resolved. The transaction cannot move forward without a resolution.

An appraisal gap clause states that the buyer will cover the gap between the contract price and the appraised value.

In the example used at the beginning of this post, the buyer may need to bring $20k to the closing table. However, adding an appraisal gap guarantee clause for $20k (or more) would automatically correct itself.

Appraisal gap coverage guarantees the seller that the buyer will cover the difference between the appraised value and the contract price.

When is an Appraisal Gap Clause Helpful?

A "seller's market" describes a housing market where homes are in high demand and sell quickly. These real estate markets tend to create bidding wars, causing homebuyers to make high offers over the original listing price.

In these scenarios, appraisers have difficulty determining actual market value. The sales data does not always support the crazy contract prices. This is when an appraisal gap in an offer contract is beneficial. It can reduce the seller's risk of losing money from a low appraisal.

When homebuyer demand pushes far past fair market value, home sellers may lose money during the appraisal process. Buyers with extra cash to cover the gap tend to win bidding wars in multiple offer situations.

How Do You Write Appraisal Gap Coverage Into a Real Estate Contract?

There are many ways to write appraisal gap coverage into a real estate sales contract. Your Realtor will be able to help you with this.

The main thing that needs to be noted is the monetary value of your appraisal gap guarantee. It's not wise to state that you will cover an unlimited amount between the sales price and the appraised value. We recommend always putting in the maximum amount you are willing to cover.

Here's an example of an appraisal gap clause as written into a sales contract:

"If the property does not appraise for the purchase price, the buyer agrees to pay up to $20,000.00 above the appraised value, but not to exceed the purchase price."

The phrasing above should cover the appraisal gap shown in the example at the top of this post. There are many different ways to word this clause. But, again, your real estate agent will structure your appraisal gap guarantee to best match your needs.

What other tactics are used to get a contract accepted?

Real estate agents have become very creative with their offer structures recently. Most real estate markets around the country are experiencing record-low inventory, so sellers are kings right now. As a result, homes can receive over 50 offers in some cases.

Escalation clauses, short closing dates, and triple earnest money are all tactics being used right now. To better understand all these tricks, check out our blog post. It covers 22 ways to accept your contracts in a strong seller's market.

18 Ways To Get Your Offer Accepted In A Competitive Sellers Market

Eventually, interest rates will rise, and new opportunities will create a balanced real estate market. But, in the meantime, home buyers will struggle to compete as demand for homes continues to break records in America.

Andrew Fortune

Hi! I'm Andrew Fortune, the founder of Great Colorado Homes and the creator of this website. I'm also a Realtor in Colorado Springs. Thank you for taking the time to read my blog post. I am always open to suggestions and ideas from our readers. You can find all my contact info here. Let me know if you need a Realtor in Colorado Springs.

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