Handling an Appraisal Gap

I think that I can safely say that most homebuyers are going to finance some portion of their purchase with a home mortgage. There are always those special circumstances where someone might not, but by-and-large there’s going to be a mortgage lender involved.

First, it’s important to remember that the bank and the lender are looking at the purchase of a home as whether or not it is a good investment. A buyer may have been preapproved to purchase a home up to $400,000 but that doesn’t mean that the bank will lend you that money on just ANYTHING. They want to ensure that the home you select is worth what they’re lending you because if you default on your mortgage the only thing the bank is really going to get is ownership of the house.

With the current market factors of many more buyers than homes available to purchase on the market, prices should increase, but oftentimes bank-perceived values don’t increase as fast as a potential buyer would like. It’s because there’s an inherent flaw in real estate valuation: the flaws of historical data.

When a borrower selects a home the only way to get an idea of what the home is “worth” is to look at recent closed sales in the area. No matter who is doing the estimate of value we’re all looking for the most-similar homes within a close proximity, but the variable that we can’t correct for is that those homes were sold weeks or even months ago. A lot can happen in the market in the matter of a few weeks, so putting in an offer can contain some risk. Basically, is the lender going to see the value that the buyer sees in the home when looking only at historical (outdated) data points?

Sometimes the answer is yes, and sometimes the answer is no.

For example, if the lender deems the value of a house to be $280,000 then the bank will only lend up to 280,000 on the purchase of that home. It doesn’t matter if the buyers were originally approved for much more, and it definitely doesn’t matter if the under contract price is higher. The bank isn’t going to budge on their value calculation (usually).

In this example let’s say that the buyer is under contract on the home at $300,000. There are some options, but none of them are particularly fun. First, the buyers and their agent can argue the appraisal. For this to go anywhere the agent better have historical data to back them up, and it better be undisputable and unbiased. Basically if there’s a sale in the neighborhood that you know about that wasn’t taken into account in the appraisal report and it sold for more and was very, very similar to the house you’re trying to buy, you submit that sale for consideration by the lender’s team. Again, it’s making an argument based on historical data.

What’s more likely is that the buyer has to figure out a way to cover the difference between the appraisal price of $280,000 and their under contract purchase price of $300,000. This means that the buyer needs to have $20,000 in cash available that they were likely not anticipating needing to have. And this is in addition to the money they need for the downpayment for the lender on a $280,000 value of home and the closing costs (escrow funding needed, fees paid, attorney costs, etc.)

If your lender approved you with a certain percentage of purchase price as down payment (for example, 20%) ask if they can approve you with less money down. The difference in the downpayment required can then be allocated to the appraisal gap. This could mean that you’re now going to have to pay mortgage insurance interest (MIP) so make sure you have a full understanding of how this will impact your mortgage payment and the fees that you pay each month.

If you are very-very lucky, you may be able to structure receiving a financial gift from a family member to help with financing your home. Make sure that you discuss this possibility with your mortgage lender as there are documentation requirements and they are extremely detailed. Basically, you do not want a financial gift to need to be repaid as this would mess up your debt to income ratios and could make it impossible for you to qualify to purchase the home. There will likely be a requirement that the person giving the gift signs a gift letter stating that the money does not need to be repaid. The person giving the gift should also consult with their tax advisor prior to making a financial gift.

Lastly, if the appraisal comes in low you can go back to the seller and ask them to drop the purchase price to the appraisal value. This used to work, but in our current market it’s not a great option. Most buyers are willingly offering more than they think the home will appraise for and will therefore waive this option as part of their original offer. It’s more likely that the seller will want to put their house back on the market and get someone to waive the appraisal contingency up front than to lose potentially thousands of dollars by dropping the purchase price down.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: