If someone wants to lend money to someone else, in most cases, they would require collateral. Naturally, this collateral should be of equal or greater value than the money being lent.
Mortgage companies and banks operate in a similar fashion. If a customer intends to buy a specific house, the institution evaluates the value of that house because it serves as collateral.
The process of assessing the value of a property is called an appraisal. To maintain objectivity, a third-party appraiser, not affiliated with the bank, conducts the appraisal. The appraiser determines the value of the collateral by analyzing the market price of the house, as mentioned in my previous explanation.
Let's consider a scenario where a customer wants to purchase a $500K house with a 20% down payment and an 80% mortgage from the bank, resulting in a $400K mortgage. The bank would only approve the mortgage if the appraised value of the house is equal to or greater than $500K. Therefore, the bank hires a third-party appraiser to confirm the value of the collateral.
If the appraised value turns out to be higher than $500K, it is favorable for the bank since they are obtaining collateral worth more than the money being lent.
However, if the appraised value is lower than $500K, the bank may not approve the mortgage based on the 20% down payment alone. This situation is referred to as an "appraisal gap."
In the case of an appraisal gap:
Buyer's Market or Neutral Market: The seller may absorb the difference between the purchase contract price and the appraised value. This is because buyers often include a loan contingency in their contracts, allowing them to back out if they can't secure the mortgage.
Sharing the Gap: Sometimes, the seller and buyer may agree to share the difference. If the buyer is responsible, increasing the down payment by the amount of the gap is a common solution to get the loan approved.
However, in a seller's market, where demand is high and multiple offers are common, sellers may not be as concerned about a buyer's appraisal gap. They may expect other potential buyers to step in if the current deal falls through. In such cases, buyers often include an appraisal waiver in their offers, indicating that they are willing to cover any appraisal gap that may arise.
If you have any further questions, feel free to ask.
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