If you’re selling your home in a hot market rampant with bidding wars that drive up the purchase offers on home sales, you may realize that your home is unlikely to appraise for the inflated purchase offer or even for your asking price.

To better understand what happens when homes appraise below the purchase price, we talked to top real estate agent Ethan Goodrich of Compass Realty in Boston, Massachusetts. Goodrich has 14 years experience and specializes in condos, luxury homes and waterfront properties.

How is the appraised value of the home determined?

It’s likely that you will sell your home to a buyer who will finance the purchase with a mortgage. According to the National Association of Realtors (NAR), 87% of home buyers finance property purchases with a mortgage. Mortgage companies require an appraisal to determine the value of a home. The appraisal helps ensure that the mortgage company doesn’t lend more than the property is worth. A third-party appraiser determines the value based on the size and condition of your home, any upgrades or improvements you’ve made, and the final sales price of comparable homes (comps) in your area.

What is an appraisal gap?

An appraisal gap is the difference between the purchase offer and the appraised value of the home. If the home appraises high (above the asking price), the gap is in favor of the buyer obtaining a mortgage. But if the home appraises low (below the purchase price), the buyer will have difficulty securing a loan for the property without bringing extra cash to the sale or renegotiating the price.

Why do appraisal gaps happen?

Appraisal gaps happen for the following reasons:

• In a hot market, market values rise faster than recent sales for comparable homes in your area
• An inventory shortage — there are fewer homes for sale than there are home buyers, creating bidding wars
• You priced your home based on recent home sale(s) for which the buyer(s) paid well over appraised value
• Property values in your area are beginning to decline
• Your home is overpriced
• Your property has been poorly maintained
• Short sales or foreclosures in your area have driven home prices artificially low
• The appraiser made an error (see how appraisal mistakes happen below)

What happens when a home appraises low?

If your home appraises for less than the purchase price, the following things can happen:

• Buyer may pay the difference. A buyer may be able to pay the difference from their savings or they may liquidate investments or retirement funds. They may also use gift funds from family members to make up the difference.
• Buyer or seller request a reconsideration of value (ROV). If either party disagrees with the appraisal, they may contest it by requesting an ROV. An ROV is requested when an appraiser has made a mistake in the appraisal, by comparing it to lesser property sales in the area, using outdated comparisons, misstating home specifications, or not taking upgrades into consideration.
• Buyer or seller may appeal to the lender for a second appraisal from a different appraisal company.
• Buyer may apply with a different lender. A buyer with good credit may seek out a different lender, who will require an appraisal, most likely from a different appraisal company. In this case, the buyer hopes that the new appraisal will come in closer to market value.
• Buyer or seller may renegotiate the purchase price. If you need to sell your home just as much as the buyer wants to buy it, you may be able to work out a deal with the buyer. You can reduce the asking price or the buyer may reduce their offer to match the appraisal. Another alternative is to meet somewhere in the middle.
• Buyer (or seller) may walk away from the sale. All of these solutions are optional and add time to the home purchase process, which may be enough of a reason for the buyer or seller to walk away from the sale. In the purchase offer, the appraisal contingency (see below) gives the buyer an out if the house appraises low and financing falls through. The inability of the buyer to secure financing is one of the most common reasons for a pending sale to fail.

What happens if the home sale falls through?

The home is “under contract” during the period of time after the buyer and seller sign the purchase agreement. This is the time when the inspection, any agreed upon repairs, and the appraisal take place. When the home is under contract, the seller and the seller’s agent aren’t usually showing the home or accepting additional offers. If the home sale falls through, the house goes back on the market. The appraisal and the reason for the failed sale are not public record.

In a hot market, the seller’s agent may have backup offers and eager buyers waiting in the wings to snatch up the home. This works in the seller’s interest. If the seller’s agent has other offers on the table, and the appraisal comes in low, the buyer will be motivated to come up with the difference rather than negotiate a lower price.

On the flip side, without backup offers a failed home sale means extended time on the market and creates wariness in the eyes of other agents and buyers. The seller may receive fewer offers and lower offers.

Goodrich says “In the sales process, it’s tough to convey to a new buyer that a failed transaction doesn’t point toward bigger issues with the home. So a good agent is heavily vetting the offer, to ensure that the transaction goes smoothly from start to finish.”

Appraisal gap guarantee vs. appraisal contingency waiver

An appraisal contingency is a clause written into the purchase offer — which becomes the purchase agreement — that states that the offer is conditional on the property appraising for the amount of the purchase price or more. The appraisal contingency protects buyers (and their lender) from paying more than a home is worth, which could put the buyer upside down in their mortgage. Cash buyers can waive the appraisal contingency (because they’re not going through a lender). Buyers who finance the property purchase with a mortgage generally cannot, unless they have significant cash reserves to cover the appraisal gap and their required down payment. For this reason, a buyer who is financing with a mortgage may include an appraisal gap guarantee clause to make their offer more attractive.

An appraisal gap guarantee is a promise the buyer makes to the seller in writing to pay the difference between the sales price and a low appraisal, typically up to a certain dollar amount. An appraisal gap guarantee may also be called an appraisal gap coverage or appraisal gap insurance, although it is not protected by a third party. With an appraisal gap guarantee, the buyer promises to cover the discrepancy between the sales price and the appraisal with their own cash. Appraisal gap guarantees are most common when the housing market is hot (a seller’s market) and sellers are aware their asking price could be higher than the appraised value of their home or buyers are offering more than the asking price, knowing that the home is unlikely to appraise for this value.

Here’s how appraisal gap guarantees work

An appraisal gap guarantee resolves the difference between the asking price and the low appraisal so the sale can move forward. A buyer’s agent may write an appraisal gap guarantee into a contract to make the offer more appealing to the seller. Or a seller’s agent may request an appraisal gap guarantee from the buyer.

Most appraisal gap guarantees have limits

Buyers may add a cap to an appraisal gap guarantee clause that indicates how large of a gap they’re willing to cover. For example, if the asking price on your home is $400,000 and the buyer offers $415,000, the buyer might include an appraisal gap guarantee that covers the $15,000 over the asking price. If the home appraises for $415,000 or higher, the buyer won’t need to cover the gap. If the home appraises for $400,000, the buyer will need to bring $15,000 cash to closing to cover the gap. If the home appraises for less than $400,000, the buyer or seller may renegotiate the purchase price or walk away from the sale.

Buyers should prove they can cover the gap

A buyer who makes an offer on your home should present you with a letter that proves they’ve been pre-approved for financing in an amount that is equal to or more than the purchase price. A buyer who agrees to an appraisal gap guarantee should also present you with proof of additional funds to cover the amount of that promise. For example, if the buyer has promised to pay a gap up to $15,000, they should be able to show proof of funds for that $15,000. If the buyer or buyer’s agent hasn’t included this proof with the offer, the seller or seller’s agent should request it.

The bottom line

In a hot market buyers tend to throw inflated offers on the table, driving selling prices well above market value. An appraisal gap guarantee is a good bet for sellers to protect the deal when the purchase price is higher than the asking price. A top real estate agent will vet a great offer and the appraisal gap guarantee with the buyer’s proof of funds to help ensure the sale goes through smoothly from start to finish.