An appraisal gap (also known as an appraisal shortfall) refers to the difference between an appraised value of a home and the purchase price promised on a sales contract. It comes into play when the appraisal falls short of the purchase price. If a buyer is using a loan to purchase the property, then the lender will not move forward with the loan at higher-than-than-appraised value using the original loan terms. The buyer would have to bring additional funds to closing above the down payments and closing costs of the loan terms.
How is This Market Different?
In more traditional markets, it’s common for the seller (or builder) to lower the purchase price to match the appraised value. While that’s not always the outcome, it is very common.
In markets that are very low in supply (number of homes for sale), and high in demand (number of buyers in the market), appraisal gaps are handled differently.
We are currently experiencing a market with historically low supply and historically high demand. With so many competing offers on properties, that has put sellers in a particularly strong position and many are demanding promises to make up for an appraisal gap to compete with the multitude of offers. While I have seen buyer and sellers occasionally negotiate on some appraisal gaps in the past, I’ve never before seen offers that include a promise to make up the appraisal gap difference. Now, it has become extremely common.
Is that Bad?
Wait…what? Buyers are promising, ahead of time, to pay over the appraised value of a home?
In a word, YES.
Isn’t that a terrible idea? It depends.
There are important factors in deciding when to buy and how much to pay. Chief among them:
What are your alternatives? Rents are very high these days and many would-be homebuyers are throwing away large sums of money every month to rent. That’s money that could be used to buy a home in order to get all of the autonomy, security and wealth-building of homeownership. If you’d be spending as much or more to rent as to buy, then that is a strong argument to buy.
Interest rates are at historical lows. If you are using a mortgage to purchase a home, then the interest rate has a direct effect in your buying power and monthly budget. A buyer purchasing a home for $270,000 at 4.75% interest would pay MORE monthly than a buyer purchasing a house for $300,000 at 3.75% interest. Well-qualified buyers are getting rates lower than 3.75%, so interest rates should rank high in your consideration of when to buy.
Keep a level head and don’t go overboard. While there are logical reasons for buying during this market, it’s also easy to get carried away. Depending on price point, paying a modest appraisal gap would still save buyers the cost of renting and the cost of a 1% higher interest rate. BUT… some buyers who are discouraged by this market are making poor decisions like skipping inspections altogether, going overboard on price, paying high appraisal gaps, giving up important protections, etc. That is NOT advisable.
What Should I Do?
For sellers who don’t have to buy, there is no losing in this market as long as you work with a strong, experienced agent who can get you the most money for your home with a smooth closing. (That's a lot more challenging than you might think, but an experienced agent will get it done.) The appraisal gap will bring you higher-than-value purchase price on your home, bringing you the best return on investment with the least amount of stress. In addition to a higher purchase price, many sellers are also able to skip on repairs.
For sellers who also have to buy, it will depend on your personal situation. Will the profit on the sale of your home make up for the extra cost of the next home? If so, you’re still winning. If not, it may be worth it to wait.
For buyers with a strong conventional loan approval, enough cash to cover their down payment, closing costs and a little extra to make up for a potential appraisal gap, then the historically low interest rates and savings on a year lease would make financial sense in this market.
For buyers with limited funds, especially in highly competitive price points, then it may make more sense for you to take some time out to save money and work on your credit until the market is less competitive.
Does that mean that all sales during this market will include paying an appraisal gap? Not at all! However, it is something to be aware of in this market, as we’ve not seen it quite like this ever before and it’s become part of a great number of recent offers and sales.
Ultimately, it’s unique to each buyer, seller and sale. Contact me for an honest, no-obligation evaluation of your personal circumstances. Even if it is worth it for you to wait, there are things we can do now to get you ready for when the time is just right! If it IS a good time for you, then don't miss the boat, as doing so would be a costly mistake!