Congrats, you beat out many other offers to win the home of your dreams! All the other offers were over the list price just like yours, but your lender’s appraisal came in below the purchase price. Now what?
This is a scenario which is becoming more common in our Central Oregon market and other hot real estate markets across the country. What does this mean for your home purchase and what is the resolution?
First off, a home appraisal is an opinion of value from a licensed appraiser who is hired by a lender. Banks and lenders will not loan more money than what their appraiser’s opinion of value comes back at. Therefore, when a home’s appraisal comes in below the agreed upon purchase price, there is a value difference called an appraisal gap. Purchase contracts used by Realtors have a financing contingency in place to protect the buyer and the lender which in part states, “Lender’s appraisal shall not be less than the Purchase Price.” If the appraised price is not at or above the purchase price, leaving an appraisal gap, the buyer and seller find themselves at a negotiation point to resolve the difference.
For example, let’s say from the above scenario that you offered $500,000 on a home which was listed at $475,000. You have some cash reserves and do not want to pay private mortgage insurance, (PMI) so you offered to put down 20% of the total purchase price, $100,000. (PMI protects the lender in case a buyer defaults on the loan but is not required with at least 20% of the purchase price down.) Both you and the seller are very happy and comfortable with the purchase price and terms as agreed. Unfortunately, here comes a curveball! Your lender’s appraisal came back with a value of $480,000. Based upon your 20% down conventional loan, the bank will now only loan you 80% of $480K which is $384,000. You now have an appraisal gap. If you will still want to avoid paying PMI, you need to come up with an additional $16,000 in cash to close (a total of $116,000; the difference between $384,000 and $500,000) or negotiate with the sellers to lower the purchase price to make up the difference. If no mutual agreement is met, you’ll be forced to restructure the loan with less down and pay PMI or walk away from your dream home.
The appraisal gap on a purchase using a low or minimum down payment loan can be a deal killer if a buyer does not have additional cash to close and a seller is not willing to concede on their bottom line. Consider the same scenario but with a 3% or 5% down payment. With a 3% down loan, the down payment stretches from $15,000 to $34,400 and with a 5% down loan, the down payment stretches from $25,000 to $44,000!
In a strong seller’s market with quickly appreciating prices, the odds are not in your favor to negotiate any type of concession from the seller. So why and how can this happen? Why should an appraiser’s valuation be different than what the market is eagerly offering? Here is your answer – A lender’s appraisal can only take into account past sales. When home prices are appreciating quickly and buyers are bidding prices upward, lender appraisals simply cannot keep up with the market trend. This is especially true in markets where inventory (housing supply) is extremely limited. There just are not enough recently sold comparable homes for appraisers to use in supporting agreed upon purchase prices.
If you are faced with an appraisal gap, you and your Realtor do have the option of challenging the appraisal or you may be able to order a new appraisal altogether. Both of these options can take time and ordering a new appraisal will cost more money. Unfortunately, the likelihood of winning a challenge is low, unless an appraiser has missed some obvious comps or information affecting the value. Your Realtor and lender can help you determine whether or not an appraisal should be challenged or if ordering a new appraisal is warranted.
If you are a buyer or a seller in this market, we strongly advise you to have expert Realtor representation. Appraisal gaps can be a thorn in any transaction, but they should not be unexpected in our market. With proper planning, discussion and strategy, there are ways your Realtor can help you avoid or negotiate these scenarios.
If this market has your head spinning, we’re here to answer your questions, guide you through the process and offer you clarity, calmness and confidence. Call us anytime. We’ll be here.
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