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Understanding the Appraisal Gap

Monday, December 27, 2021   /   by Sarai Diaz

Understanding the Appraisal Gap

What is appraisal gap and appraisal gap coverage? This is stuff that we don't talk about in real estate all the time, but in this a very competitive market and this is coming up on a lot of offers and this might be the reason why you're not writing a strong enough offer to get the house that you want. So we're going to use really simple numbers today and we're going to use really basic loan structures.

We're going to use a $100,000 offer (which as you know in this market really doesn't exist) and we'll talk about a loan that is an 80/20 loan.

So, this is a 80% loan to value 20% is the down payment. This is pretty standard in a conventional loan. In that situation, the buyer would need to bring $20,000 down to buy a $100,000 house, and the bank would lend them the $80,000. The purpose of the appraisal is for the bank to establish the value of the home, because we have to remember, banks are taking a risk by  lending you money. So, they have to assume that you're going to default (WHAT DO YOU MEAN "DEFAULT"? ASSUME THE BUYER IS GOING TO MISS PAYMENT?) and they have to make sure the value of the home is there to cover their risk of lending you those dollars. So in a typical situation, the appraiser would come in and say "Yes, this house is worth 100,000. So your $20,000 satisfies the bank's 80% loan.

What happens if the appraiser says the house is worth 90,000? Well now 80% of $90,000 is only 72,000, But your offer is still 100,000 and now you have to bring in $28,000 to satisfy the loan.

Let's extrapolate that to a larger purchase price so that it kind of makes more sense. You have a $500,000 offering on a house. So you're going to be bringing 20% of that into the deal. So that's $100,000. That means the bank would be bringing a $400,000 loan to satisfy the 80/20 loan. If the appraiser values the home at $450,000, that means that 80% loan would only be $360,000. But you still have an offer for $500,000. So now instead of bringing $100,000 into the deal, you have to bring $140,000 into the deal.

Now, you're seeing a lot of houses where people are offering asking price over asking price and then they're putting appraisal gap coverage in because they know they're driving the price of the house up so high, so if the appraiser comes in low, they have extra cash in the bank and they're just paying that difference so that they can still get their loan and keep that price.

This is the other reason why you'll see real estate agents get a little nervous when prices on that offer starts getting too high because they know they might fall in a situation where if the appraisal comes in low, either the buyer is not going to be able to satisfy the loan or they're going have to renegotiate the price.

If you feel like you've been writing a lot of offers on homes, but you can't seem to win the offer, it's most likely because there's somebody else out there that's also bidding on the home that's bringing extra money into the deal to cover any appraisal gap. So when you're a listing agent and you have a seller, you're going to be coaching them and saying, “Hey, this offer is going to be stronger because, even though they've raised the price higher, they have money to cover the appraisal gap.”

Hopefully this helps you understand the concepts of appraisal gaps a little bit easier. It really is important to remember to find a realtor and a lender who understand this concept really well so that they can build you a very strong offer and sometimes even create some gap coverage where it may not have even been there before. If you were a 20% down person, they might be able to move you into a 10% loan, a 5% loan or a 3% loan, freeing up some of your money to cover the appraisal gap.

Wizard Wednesdays are hosted by Josh Orrantia, Broker and owner of Country Real Estate. This is the day that we try to take somewhat complicated real estate terms and break them down into a 101 to make them easy for you to understand.

  tehachapi, real estate, realtors, broker, loans, appraisal, bank loans, home loans, offers on a house

Country Real Estate
107 E. Tehachapi Blvd.
Tehachapi, CA 93561

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