What Is Appraisal Gap Coverage and How Does It Work?

In today’s competitive real estate market, home buyers often encounter situations where their offer price exceeds a property’s professional valuation. This discrepancy creates a potential hurdle in the home buying process, commonly referred to as an “appraisal gap.” Navigating this market requires understanding how property values are determined and the financial implications.

Understanding the Home Appraisal

A home appraisal provides an independent, professional assessment of a property’s market value. This evaluation is performed by a licensed appraiser, typically at the request of a mortgage lender. The primary purpose for a lender is to ensure the loan amount is supported by the property’s actual value, protecting their investment. The home serves as collateral, so the lender wants assurance they can recoup funds if a borrower defaults.

Appraisers consider various factors to determine a home’s value. These include recent sales of comparable properties, often called “comps,” within the same area. They also assess the property’s physical condition, age, size, layout, and any significant upgrades or renovations. The home’s location, including its proximity to amenities, schools, and overall neighborhood characteristics, plays a role. Lenders typically base their loan amount on the lower of the agreed-upon purchase price or the appraised value.

Identifying an Appraisal Gap

An appraisal gap occurs when the purchase price agreed upon by a buyer and seller is higher than the home’s appraised value. For instance, if a buyer offers $400,000 for a home, but the appraisal comes back at $380,000, there is a $20,000 appraisal gap. This situation frequently arises in competitive seller’s markets, characterized by high buyer demand and limited housing inventory.

In such markets, bidding wars can push sale prices beyond what recent comparable sales data supports. Appraisals rely on historical sales data, which can lag behind rapidly appreciating market prices. When this disconnect occurs, the lender will only finance the loan up to the appraised value. This means the buyer is responsible for covering the difference between the lower appraised value and the higher contract price out of their own funds. Without a resolution, this gap can halt the transaction, as the buyer may not have the additional cash or the seller may not agree to a price reduction.

How Appraisal Gap Coverage Works

Appraisal gap coverage is a contractual commitment by a home buyer to pay the difference between the property’s appraised value and the agreed-upon purchase price, up to a specified amount or the full gap. This commitment is typically included as a clause in the purchase offer. It is not an insurance policy, but a pre-agreed financial obligation undertaken by the buyer. By including this clause, the buyer assures the seller they will provide additional cash at closing to cover any shortfall, allowing the transaction to proceed even if the appraisal comes in low.

For example, if a home is under contract for $410,000 but appraises for $390,000, creating a $20,000 gap, and the buyer has committed to $20,000 in appraisal gap coverage, the buyer would bring that additional $20,000 to closing. This strategy makes a buyer’s offer more appealing to sellers in competitive bidding situations, as it reduces the risk of the deal falling apart due to a low appraisal. It signals the buyer’s strong commitment and financial capacity to close the sale. The specific language and amount of coverage are negotiated and documented in the purchase agreement.