The home appraisal is an important step in the mortgage application process. Before a mortgage loan is approved by a lender, the property must be appraised so that the lender can determine if the purchase price is at or below the market value of the home.
Depending on the size of your down payment, the lender’s practice, or the risk of the loan, the lender may decide to perform the appraisal remotely (a desktop appraisal), or they may decide to order an in-person appraisal which would be performed by a professional home appraiser.
Many borrowers find the appraisal process confusing – they wonder, why does the lender require an appraisal when the purchase price could be used as the fair market value?
Quite simply, the lender wants to protect their investment and the potential of getting stuck with a property that is worth less than the amount borrowed by the buyer because some buyers make offers for more than what the home is worth.
The appraisal is an unbiased estimate of the fair market value of the property.
As an illustration, let say you found your dream home, and the purchase price was $600,000, which is an amount that you are pre-approved for. Since you are applying for a mortgage, the lender wonders if $600,000 is really what the home is worth, so they will order for the home to be appraised.
The appraised value is at or above the purchase price: In this, case the mortgage loan will proceed and you’ll likely receive an approval.
The appraised value is below the purchase price: You’ve got yourself a potential problem here; if you included an appraisal condition on the offer, you can simply ask the seller to reduce their price to match the appraised value. However, if you did not include an appraisal condition on the offer, you will have to make up the difference by increasing the amount of your down payment, or your mortgage application will be declined.
Appraisers determine the market value of a home on several factors such as home location, home size, condition of the property, and the value that other similar nearby properties have sold for within the last six months.
Getting an accurate home assessment is important because lenders use the appraised value to decide whether to extend a mortgage or not.
Once at the property, the appraiser starts by touring the home, measures every room while taking notes on a checklist and inspect every part of the home in detail.
Here are the main factors that a home appraiser looks at:
The appraiser will analyze about 3 – 5 similar, nearby homes sold within the last six months; the older the data, the less relevant it becomes because market prices can change rapidly.
It is said that the market value of a product is equal to what another independent party is willing to pay for it. The market is the collective opinion from buyers on what an item is worth, and any changes in that collective opinion will be reflected in what buyers are willing to pay.
For example, when interest rates rise, the demand for homes drop; why? Because fewer people are willing to pay the higher interest rates which translates into fewer people looking to buy homes and that drives prices down.
Here is where the old saying Location, Location, Location becomes relevant. Some neighborhoods have homes that are worth more than other neighborhoods, and sometimes even homes on the same street can differ in price if for example one home backs to a ravine, while the other backs to another property.
To gauge how prices differ from one neighborhood to the next, home appraisers will again rely on sold prices of similar homes within the same area and account for differences in features of the homes being compared.
Another key step in the appraisal process is visiting the home. The home appraiser will visit the home in-person to make a full and thorough assessment; the appraiser will measure the square footage and perform a thorough evaluation of the main elements that influence a home’s market value such as:
The size of the lot and the home’s square footage are very important. A wider frontage represents more value to the property; the same goes with large backyards or homes that back to a ravine or a nice park.
Buyers pay a premium for certain things, so the appraiser needs to consider all those things. One home may be worth more than the other even if both homes are side by side.
The most important elements of what makes a property are the foundation walls, the exterior, the roof, doors, and windows. The appraiser will pay particular attention to those areas since damage to any of them significantly affects the value of the property.
Remember that the lender needs to find out what they are investing in, and the appraiser’s job is to report back to the lender about the current market value of the property.
The appraiser will inspect the condition of flooring, the plumbing, the electrical and all rooms including the kitchen, bedrooms, and bathrooms, as well as take note of any improvements done to the home.
For instance, new floors, a new kitchen or bathroom, or a renovated basement are all things that can increase not just the value but also the desirability of a home. All those factors will be taken into account when the appraiser determines the appraisal value.
Appraisers don’t care about the décor; they ignore it. What’s more important is the condition of the property, the layout the size and the price other similar nearby homes sold for within the last six months.
Particularly important to a home appraiser are items that deduct value from the home such as things that are broken or that need repair. They also will make adjustments for items that add value to the property or that make it more desirable such as home renovations.
A recently renovated home should sell for a higher price that’s not been renovated, no two homes are perfectly the same. As the appraiser evaluates the condition of each key feature in the home, he or she must make adjustments to reflect those key differences on the value price.
A home’s market value is what buyers are willing to pay for a property so it is consumer drive; an appraised value is driven by the opinion of an expert who gathers data to form an opinion of the home’s value.
To illustrate let’s assume Mr. Seller listed a property for $600,000; Mr. buyer wants to buy it and offers $550,000. They then agree on a price of $570,000, so the market value becomes $570,000.
The buyer then applies for a mortgage and the lender orders an appraisal; the appraiser looks at recent sales over the last 6 months, factors in key differences, condition of the homes, functionality, market, and size, but concludes the home is worth $590,000.
The lender will use the appraised value to approve the mortgage application, but the appraised value cannot be lower than the purchase price or the mortgage application might be declined.
Once an appraiser has submitted an appraised value that is lower than the purchase price the lender will likely decline the loan. When this happens many people try to submit comparable properties, but that attempt will likely fail because the underwriter needs a document they can attach to the file stating the appraised value is lower than or equal to the purchase price.
If your contract allows it your best options are:
If the contract is firm and you must go ahead with the purchase your best options are:
Buyers should consider including a home appraisal condition or a mortgage financing condition on their purchase agreement to avoid any risk that could seriously derail their chances of getting a mortgage loan approval.
The goal of a home appraisal is to get an estimate of a home’s value, while the home inspection’s goal is to provide an opinion of the physical condition of a home.
The last step in the appraisal process is preparing the appraisal report and submitting the report to the lender. The home appraisal report includes the appraiser’s professional opinion of the home’s value as well as the data points used to validate the value including:
Lenders typically do not share the appraisal report with the mortgage applicant, or with the seller, but if the appraised value is below the purchase price the mortgage loan will likely be declined.
During the mortgage approval process, it is the lender that will order the appraisal be done; however, you will have to pay for it, either directly to the appraiser, or the cost will be included as a fee to your mortgage loan. The appraiser will usually send the report directly to the lender.
Even though you, the buyer and the seller have agreed on a price, the deal might not go ahead if the appraisal value comes in lower than the purchase price.
The way you protect yourself is by including an appraisal condition on your offer. If the appraisal value comes in lower than the purchase price, you will have the option to:
However, if you have done your homework and made sure your offer amount is a fair amount you have nothing to worry about because the home will appraise well. BUT, do yourself a favor and include an appraisal condition on your offer.
You should check out our Home Buyer’s Online Course to learn more about the factors that determine a home’s value and step-by-step instructions of the home buying process.
This is an interactive course designed in an easy to understand format where you will learn how to buy the home you want, at the price you want, and achieve successful homeownership.