Quick Take: Appraisal Gap Normalizes Amid a Cooling Housing Market

Contract-derailing appraisals are one less thing to worry about as prospective homebuyers brace for higher mortgage rates

Quick Takes:

• In October 2022, 6.3% of pending home sales were appraised at or below the contract sales price, down 0.1% from September 2022.
• A year ago in October 2021, 11.2% of pending home sales were appraised below the contract sales price.
• With the housing market expected to continue to level off in the coming months, the appraisal gap will likely revert to the normal 7% to 9% range that prevailed before the pandemic housing boom.

In April 2022, the appraisal gap reached an all-time high of 20% when home prices surged 2.88% in a single month or 20% when compared on a year-over-year basis. However, since May 2022, the appraisal gap has seen a precipitous decline as rising mortgage rates sent home sales plunging and leveled prices.

An appraisal gap occurs when a house’s appraised value falls short of the sales price. The risk of overpaying in a heated homebuying market with frenzied bidding wars offers one explanation for the elevation in the appraisal gap.

The fast-moving market prior to May of this year also presented challenges for appraisers as rapidly rising home prices can quickly render recent comp sales obsolete and increase the likelihood of appraisal lags.

In mortgage underwriting, lenders use the lower number between the contract sales price and appraised value to determine the loan-to-value ratio (LTV). In the presence of an appraisal gap or a smaller denominator, the LTV will be higher, which may impact loan approval or closing. Even when approved, a higher LTV can make a loan less affordable if it ends up in a higher LTV underwriting bucket that requires more minimum mortgage insurance coverage.

As of October 2022, national home prices have slid for four consecutive months due to rising interest rates and plunging home sales. According to the CoreLogic National Home Price Index, the last time that home prices sustained consecutive month-over-month declines was at the tail end of the last housing recession a decade ago.

If sliding home prices result in more homebuyers entering the market, they may find a silver lining in the developing market trends. The risk of a potentially contract-derailing appraisal gap has fast diminished and is one less worry as buyers continue to brace for higher mortgage rates.