Introduction

Buying a home is an exciting and momentous step in your life. To get a mortgage to purchase your dream home, your lender will need to get an appraisal on the new home. How this appraisal turns out will determine if you can buy this home and under what terms. In this article, we will discuss what appraisals are and why they matter for your mortgage.

Understanding Appraisals

An appraisal is a professional assessment of a property’s market value conducted by a licensed appraiser. The appraiser evaluates various factors such as the property’s size, condition, location, and comparable sales in the area to determine its appraised value. Although the appraiser will look at the other factors, the property’s value will largely be determined by the values of comparable sales over the last year in the general location of your property. This value is a critical benchmark in the mortgage approval process, influencing the amount a lender is willing to lend you and under what terms. Although an appraisal is a critical part of both a purchase mortgage and a mortgage refinance, this article will focus on purchases mortgages for simplicity. For a refinance, most of the concepts are the same except you are looking at an estimated value versus a purchases price, and there are no realtors involved.

Why Appraisals Matter

1. Risk Mitigation for Lenders: The primary purpose of the appraisal is to protect the lender from financing a property that is worth less than the purchase price. By determining the property’s value, lenders determine the loan-to-value ratio (LTV) of the mortgage which is the loan amount divided by the appraised value. If the appraisal comes in lower than expected, than the LTV ratio is higher than agreed to when the borrower applied for the mortgage. To offset this risk, the lender may require more private mortgage insurance (PMI) and/or more cash to offer the same loan terms to the borrower.
   
   
2. Protection for Borrowers: Although appraisals primarily benefit the lender, they also may offer protection for borrowers. A fair and accurate appraisal suggests that the buyer is not overpaying for a property. It sets a reasonable and justifiable purchase price as determined by the appraiser. In a perfect world, the appraisal prevents the buyers from getting a mortgage on a property where the price is greater than the market value. Unfortunately, the appraisal is a somewhat subjective determination of the property’s value that does not necessarily capture the fast-moving dynamics of the real estate market. Just because the appraised value comes in lower than the appraisal does not mean the seller should drop the price or that buying the property for more than the appraised value is a bad idea.
   
   
3. Equity Considerations: Appraisals also play a role in determining the equity a homeowner has in their property. As property values fluctuate over time, regular appraisals can help homeowners understand the current market value of their home. This knowledge is valuable for those looking to leverage their home equity for various financial purposes, such as refinancing their rate, doing a cashout refinance or securing a home equity loan.

The Appraisal Process

Now that we understand the importance of an appraisal in getting a mortgage loan, let’s look at the steps involved in the appraisal process:

1. Engaging a Licensed Appraiser: Residential mortgage lenders typically use an appraisal management company who hire licensed appraisers that are independent third parties. These professionals have the expertise and knowledge to provide an unbiased and accurate assessment of a property’s value following standardized guidelines. There are several mortgage rules that limit the form and frequency of communication between the lender and appraiser to ensure that lender does not have any undo influence over the appraiser or appraised value.
   
   
2. Property Inspection: The appraiser typically conducts an inspection of the property. This includes examining the interior and exterior, assessing the overall condition, and noting any improvements or repairs needed for safety reasons. The overall condition of the property is of much less importance than most people think. If the property has been recently updated and is in great condition, it will not be worth more than other comparable properties in the area if they are all in good/great condition as well. To complete the appraisal report, the appraiser will have to see that the property is habitable with working electric, gas, and plumbing. If the appraiser sees safety hazards or other items that limit the property’s habitability, they will need to be addressed before the appraisal report can be completed. However, the purpose of the appraisal is not to give the buyer a list of items to be fixed. That is a home inspection.
   
   
3. Comparable Sales Analysis: The most crucial aspect of the appraisal process involves comparing the subject property to recently sold properties in the area. These properties are called comparable properties or comparables. The appraiser considers factors such as size, condition, age, and location to determine the comparables that will best approximate the value of the subject property. The appraiser will attempt to find comparables that have been sold in the last year within proximity to the subject property. If the subject property is in the city, proximity may be a matter of blocks whereas proximity may be miles away in the suburbs. The appraiser will try to match the number of rooms, bedrooms, bathrooms, and square footage of the comparables with that of the subject property. Depending on the inventory of recent sales, and quite often the time of the year, this can be easier said than done. Because of the complexity of finding good comparables, determining the appraised value of a property can be more subjective than most people might imagine.
   
   
4. Report Generation: Following the inspection and comparable analysis, the appraiser compiles a comprehensive report detailing their findings. The most important part of the report is the comparison of the subject property to the comparables selected by the appraiser. If the square footage, room count and/or condition of a comparable does not match up to the subject property, the appraiser will adjust the values of the comparables so that they are a better fit for the subject property. The sizes of these adjustments are subjective which can make the values of the comparables subjective as well. The appraisal report includes the adjusted value of each comparable laid out next to the final estimated value of the property. Although the appraiser will typically rely on no more than three primary comparables, the final value of the property is not an average of the values of the three top comparables. In fact, the appraiser may rely almost entirely on the value of one primary comparable if its characteristics are a close match to the subject. In addition to showing values for the property and its comparables, the appraisal report also shows pages of information on the subject property, the neighborhood and local market trends. Importantly, the appraisal report will show if the appraisal was completed “as is” or if it is “subject to” the completion of the property or the resolution of a safety issue.
   
   
5. Submission to Lender: The completed appraisal report is submitted to the lender. The lender reviews the report to ensure that the property’s value aligns with their lending criteria and may ask the appraiser to provide additional information to support the appraised value. Most lenders offer a mortgage with an LTV based on the lower of the appraised value and the purchase price. If the original LTV of the mortgage was 90% and the appraised value of the property came in lower than the price, then the lender may require that the purchase price be lowered to equal the appraised value to offer the same terms as the original loan at a 90% LTV. The seller may not be willing to lower the price for any number of reasons. They may believe there is an error or omission in the appraiser report (see below) and want to have the value appealed to move forward. Because of the subjective elements in an appraisal, the seller may want to find another buyer at the original price, particularly if there were multiple offers on the property originally. The seller will pick a new buyer if they think that the new buyer’s lender may have a higher appraised value. This may happen because appraisals can be subjective. If the seller will not drop the purchase price to equal the appraised value, then the buyer may have to offer additional cash to raise up the LTV on the mortgage and keep the original terms of the loan. If the borrower does not have additional cash, the lender may be able to increase the PMI on the loan at a relatively small cost to the borrower. Sometimes the seller and buyer agree to comprise, and the new terms of the home purchase are not terribly different than they were at the outset. When a property is appraised for a value lower than the purchase price, it requires a skilled lender to negotiate with the seller and come up with a mortgage structure that works for the borrower. This is when your Lakeside mortgage loan consultant is of the most value to you and your family.
   
   
6. Appraisal Appeal: Because the role of the appraiser is important to the lender and the integrity of the mortgage process, a lender cannot ask an appraiser to increase the appraised value simply to make the seller or buyer happy. If the appraisal comes in less than the purchase price, the lender does have some options to appeal the value with the appraiser. The lender can ask the appraiser to take another look at the value if there is an obvious error in the appraisal report. Appraisers are human and they make mistakes like anyone else. The most correctable error is when an appraiser fails to consider some of the living space at the subject property. An appraiser may miscount the number of bedrooms, accidentally omit the square footage of a room, or never be told that there is a parking spot that comes with the property. This can quickly be corrected. On the other hand, the appraiser will not consider if the correct adjustment for a comparable with one less bathroom should be $15,000 or $25,000 in value. The adjustments made to comparables by the appraiser are typically not open for discussion or negotiation. A less reliable way to appeal an appraisal is to argue that a comparable property on the appraisal report has been accidentally omitted or should not be there in the first place. In this case, one of the realtors may have a comparable that they used in a market analysis which you can argue should be part of the appraisal valuation. The lender can submit this potential comparable to the appraiser with an argument as to why it should be used. Quite often, the appraiser considered this comparable and decided not to use it for valid reasons. But there are times when the appraiser missed it. Unfortunately, it is usually hard to add or omit a comparable because the criteria for a realtor to use a property for a market analysis is much less stringent than it is for the appraiser to use the same comparable in their appraisal analysis. As you can see, this can be a complicated process. For this reason, it is critical to have a competent lender and realtor on your team to ensure that you can navigate the complexities of an appraisal appeal.

Challenges and Considerations

While appraisals are a crucial step in the mortgage process, they can also pose challenges and considerations for both borrowers and sellers:

1. Market Fluctuations: Property values can fluctuate due to changes in the real estate market. Rapid market fluctuations may lead to disparities between the agreed-upon purchase price and the appraised value, potentially impacting the mortgage approval.
   
   
2. Appraisal Contingencies: Many real estate contracts include both mortgage and appraisal contingencies, allowing buyers to renegotiate or withdraw from the deal if the appraisal comes in lower than the agreed-upon purchase price. These contingencies provide a safety net for buyers but can also lead to renegotiations and delays in closing.
   
   
3. Home Improvements and Renovations: Upgrades or renovations made to a property can influence its appraised value positively. However, not all improvements guarantee a significant return on investment. An updated kitchen may look wonderful and help you fall in love with the home, but it does not add any square footage to the property and may not distinguish it from other comparable properties with decent kitchens. It is essential for homeowners to carefully consider the potential impact of renovations on a property’s value.

Conclusion

In the homebuying process, appraisals stand out as a vital thread that weaves together the interests of buyers, sellers, and lenders. These professional values protect lenders from undue risk but may also safeguard the interests of buyers. As you look to purchase a home, understanding the significance of an appraisal and its impact on your mortgage approval will help you be better prepared to complete your purchase. The ups and downs of getting a property appraised can be very jarring so it is crucial to have a competent lender to guide you through the process. To have your bases covered, make sure that you contact your Lakeside Bank mortgage loan consultant before you begin looking for a home.