Weekly mortgage Q&A: Everything you need to know about appraisal gaps at closing

You’re just about to close on the home of your dreams. The documents are signed and your closing date is set. The lender issuing your mortgage just has to conduct an appraisal of the property you’re going to buy, to make sure all the numbers line up. Unfortunately, your lender’s appraisal comes back saying it looks like you’re going to overpay for the property. The offer you’ve made doesn’t match the home’s market value, and the lender isn’t going to give you the full amount of financing you need.

This is known as an appraisal gap, and it can scuttle any real estate deal in a competitive market like the one we’re in now if buyers aren’t prepared for it.

In many places today, buyers need to be ready to cover the appraisal gap — basically the difference in how much financing they can get versus the price they’ve offered — with cash at closing.

It’s important to think about appraisal gaps ahead of time and understand how they operate. Bankrate spoke to Angelica Olmsted, an agent with RE/MAX Professionals Cherry Creek in Denver to learn more about how they work. She said in her market, appraisal gap coverage has become a necessary part of every offer, and buyers need to be prepared.

Our conversation has been edited for length and clarity.

What is an appraisal gap?

Essentially any sort of coverage the buyer is bringing to the table that will cover the difference between the list price and the offer price.

One of the things that is very unique about the market especially here in Denver is that appraisal gaps are a requirement. It used to be that an appraisal gap really set you apart, it really differentiated an offer, however now, it’s essentially required.

I consider it cash at close. Your appraisal gap, in addition to closing costs and your down payment and appraisal and inspection, this is an additional cost that buyers are bringing to the table. At the end of the day we don’t know what we’ll need to bring this to full value, but assume we will need to bring something.

How should buyers address it in their offer?

First and foremost — I’m a little biased — but I think having a good agent on your side is crucial. I have definitely seen in this market people signing themselves up for appraisal gaps that they don’t really understand. Typically you want a really good agent on your side and run you comps. Is the property priced correctly and what do comparable properties look like in that area?

The verbiage that agents use when writing an appraisal gap is important. You want to make sure the contract only holds you responsible for a certain amount of money, and that it’s only used to cover the difference between appraised value and your offer if your offer is higher than what your bank will lend you.

For example, “Buyer agrees to pay $XX,XXX towards an appraisal gap between the list price of $XXX,XXX and the final contract price. Buyer does have proceeds to bring the additional funds to closing.”

The important thing to call out here is the “between the list price” verbiage, to cover the appraisal gap only from the list price up. We don’t want to sign the buyer up for a gap if it appraises for lower (and the agent overpriced from the start). It basically adds a top and bottom to the appraisal gap.

If the gap exceeds the coverage we write in, the buyer and seller would need to renegotiate extra coverage or a change in the price.

What how common is this? And how much of a stretch can it be for buyers?

It’s one of the most important things to understand before you even start going to look in your house hunt. The reality of this is it’s impacting first-time homebuyers the most. I really make sure I address this in the very beginning.

People need to understand, let’s say they have $100,000 going into a purchase, they may not be able to use all of that money toward their down payment, because some of it will be required for things like closing costs or the appraisal gap.

I’ve found that using actual numbers and then I bring in a couple examples in that pricepoint so they can understand the market. Actually putting it into perspective of a thing that they are looking for makes a lot more sense than hypotheticals.

What should they do if they can’t afford to cover the gap?

Typically if you’re the listing agent, you’ll ask for proof of funds. With this crazy market one of the things that we’re seeing a lot more frequently is that deals fall through. Having the agent not only protecting you in the verbiage and in writing, and explaining it to you and having them explain it back is the only way they’ll understand it.

That’s why it’s so important to work with an agent who is familiar with gaps and doesn’t write in terms you won’t be able to afford in your offer.

Anything else?

Having a local agent is really important because there’s not a textbook answer of how appraisal gaps should be written. Making sure you’re doing your homework and not just blindly providing 10 percent or 15 percent over list. You really have to look at each property individually to come up with a good number for your appraisal gap.

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