What do mortgage lenders do when a property appraisal is below the purchase price?
When a property appraisal comes in below the purchase price, it creates a gap between the agreed-upon sale price and the home's perceived market value. This situation, known as an appraisal gap, can delay or derail a mortgage transaction, but lenders and buyers have several options to address it. Understanding these options helps borrowers navigate the process with clarity and avoid costly surprises.
What triggers an appraisal gap?
An appraisal is an independent estimate of a property's market value, typically required by the lender to ensure the loan amount does not exceed the home's worth. If the appraised value is lower than the purchase price, the gap represents the difference. This can happen due to a rapidly changing market, overpricing by the seller, or unique features that don't align with comparable sales data. Lending guidelines, especially from government-backed programs like FHA, VA, and USDA, have strict limits on how much appraisal values can deviate from purchase prices.
Five common paths forward
When an appraisal comes in low, lenders and borrowers typically evaluate these options in order of practicality:
1. Renegotiate the purchase price
This is often the first step. The buyer and seller can negotiate a new price that matches the appraised value. Many purchase agreements include an appraisal contingency that allows the buyer to back out or renegotiate if the appraisal is low. If the seller agrees to lower the price to the appraised value, the loan can proceed as planned without additional out-of-pocket costs.
2. Challenge or request a reconsideration of value
If the buyer or seller believes the appraisal is incorrect, they can request a reconsideration of value from the lender. This involves providing the appraiser with additional comparable sales, property improvements, or market data that support a higher value. Lenders follow strict guidelines for reconsideration requests, and the appraiser is not obligated to change their opinion. This process can take several days and is not guaranteed to succeed.
3. Increase the down payment
If the loan amount is based on the lower appraised value, the buyer can make up the difference by increasing their down payment. For example, if the purchase price is $300,000 and the appraisal is $280,000, the lender will base the loan on $280,000. The buyer must then bring additional cash to cover the $20,000 gap. This often requires the buyer to have reserves beyond the standard down payment and closing costs.
4. Pay for the gap out of pocket
Some buyers choose to pay the difference between the appraised value and purchase price in cash, known as an appraisal gap payment. This is separate from the down payment. For instance, if the down payment is 20% of the appraised value ($56,000 on a $280,000 appraisal), the buyer would also need to bring $20,000 additional cash to bridge the gap. This approach can preserve the original purchase agreement but requires substantial liquid assets.
5. Cancel the contract
If no other option works and the buyer has an appraisal contingency, they can legally back out of the contract and recover their earnest money deposit. Buyers without an appraisal contingency may lose their deposit or need to negotiate with the seller. This is a last resort, especially in competitive markets.
How different loan types handle low appraisals
Conventional loans: Often require a minimum down payment of 5% to 20%. A low appraisal can force a larger down payment to meet loan-to-value requirements. Private mortgage insurance may be necessary if the down payment drops below 20% of the appraised value.
FHA loans: The appraisal is valid for 120 days and is tied to the property, not the buyer. FHA has strict guidelines; if the appraisal is low, the seller must reduce the price unless the buyer pays cash for the difference. FHA allows sellers to contribute up to 6% toward closing costs but cannot directly cover the appraisal gap.
VA loans: The VA requires the appraised value to equal or exceed the purchase price. If it doesn't, the buyer can request a waiver of the appraisal requirement (rare), negotiate, or pay the difference in cash. The VA does not allow the seller to pay for the appraisal gap directly.
USDA loans: Similar to FHA and VA, the appraised value must support the purchase price. The buyer must cover any gap with cash, see the seller lower the price, or request a reconsideration of value.
Practical tips for buyers facing an appraisal gap
- Review your purchase contract: Check for an appraisal contingency and understand the timeline for responding. Most contracts give 48 to 72 hours to act.
- Communicate with your loan officer: They can explain how the gap affects your loan-to-value ratio and monthly payment, and whether you have the resources to cover it.
- Get a second opinion: Some lenders allow a second appraisal if the first is disputed, especially if you have strong evidence of an error. This is not automatic and usually requires a fee.
- Consider a different loan program: Switching from a conventional to an FHA or VA loan may change appraisal requirements, but this can delay closing and requires re-qualification.
- Prepare for unexpected costs: Even with a successful negotiation, closing costs and escrow adjustments may still apply. Always have a financial cushion.
Remember, each situation is unique. Consult a licensed loan officer, real estate agent, or attorney to review your specific contract and loan terms. They can help you weigh the costs, risks, and timelines of each option.