A mortgage is a loan that uses real property (a house or condominium) as collateral. An appraisal is the document used by lenders to evaluate the collateral of a loan and educate the lender about the property. Appraisers are responsible for informing the lender about the structure of the home, the neighborhood, home prices in the area and what the subject property is worth compared to other similar homes in the area. An appraisal can be used by both the lender and the buyer to become more informed about the property.
When an appraiser is evaluating a property they are providing both an objective view of the property as well as a somewhat subjective analysis. The objective part includes the statistics on the home such as size, age, type of construction, room count, etc. It also includes information about the area such as location, zoning, proximity to local influences on value such as schools, industry, landfills, waterways, etc.
The appraisal also lets the lender know if anything appears wrong with the home that lender may want to know about. If a roof is leaking and the water is pooling up knee-deep in the basement of the home, the lender will want to know about this before they lend out on this collateral. Up until December 2005 FHA required that the appraiser complete an extensive checklist indicating the condition of the home. This checklist process often resulted in the lender requiring repairs to be completed to the home in order to secure FHA financing. While this checklist process has been eliminated from the FHA valuation process, both FHA and VA mortgages tend to be more concerned about the condition of the home than conventional loans and will tend to express greater concern about any repairs or deficiencies that the appraiser notes. Keep in mind that appraisals are not the same as home inspections done by licensed home inspection companies.
An appraiser will use the statistical information about the subject property and compare it to at least three other nearby homes of similar construction called “Comparables” or “Comps”. Appraisers look for homes that are close to the subject property. Depending on the neighborhood, the appraiser may limit his search to homes within ½ mile if the subject property in an urban setting and several miles if the area is rural. The appraiser is also looking for similar size and construction. If the subject property is a 1500 square foot brick ranch then the appraiser will be looking for other brick ranch homes of approximately 1500 square feet.
The appraiser is performing an analysis of a home and effectively saying “Based on the features of the subject property as compared to other similar homes that have recently sold in the area, the subject property is worth $____”. The analysis should reflect the price the typical buyer would pay for the subject property based on what they are paying for other similar homes in the area.
When the subject home is slightly different than the comparable, the appraiser will make adjustments to the value of the subject property based on those differences. If a subject property has a two car garage and two bathrooms and the comparable has a one car garage and 1 bathroom then the appraiser will note the differences on the appraisal. The appraiser will then note what a typical buyer would pay for these differences and indicate that amount on the appraisal. If the comparable home sold for $140,000 and the appraiser feels that the typical buyer would pay $8000 more for the additional features then the subject property would be appraised for $148,000 compared to the other property.
In a perfect world all appraisals would result in the same value. However, since all homes have features that make them more or less valuable to a buyer, there is no set price for a home. Swimming pools are a great example. An active family with teenage children may desire a swimming pool as opposed to a retired couple who may want nothing to do with the care and upkeep of a pool. As a result, a pool that costs thousands of dollars to install may actually be a hindrance if the people looking at buying the home are not interested in a pool. Tri-level homes, corner lots, extreme decorating themes and homes close to a school are other examples of home features that are not bad by themselves but that may be a hindrance in selling. Appraisers need to take all of these differences into consideration and apply a dollar amount to them. Sometimes there may be features such as a pool or detailed decorating that although high in cost adds little or no value to the home when measured in an appraisal.
Another component that influences value is the motivation of a seller. A seller (of either the subject property or the comparables) that has contributed to the buyers closing costs may have inflated the price to do so. If the seller is highly motivated to sell may have reduced the price of the home to insure a faster sale. Job transfers, estate sales, divorces or anything that encourages a fast sale may lower the price of a home. If the home is one that has been foreclosed on by the lender, you may find a home well below value. This can wreak havoc on a market where you have both distress sales such as foreclosures and typical sales taking place. This mix frequently will drive down the appraised values because of the presence of the distressed sales.
On a purchase transaction lenders define the value of a home as the lesser of the sales price or the appraised value. The customer wanting to use a high appraised value to better their loan terms can usually refinance after the purchase and take advantage of the appraised value at that time. Someone planning on purchasing and then quickly refinancing should check with the lender to make sure that there are no penalties if you refinance.
I have known many customers that paid more for the home than it appraised for. In those instances it was usually that the other homes in the area didn’t met their exact needs and they were willing to pay extra for the additional features, improvements or decorating that the seller had done to the home they were buying. In those cases the loan was on the appraised value not the sales price and sometimes required the customer to put a larger amount down on the home.
After you have looked at a number of houses you will begin the process of doing your own mini-appraisals. If you look at enough homes, you will be able to look at a home and determine if that home is priced high or low based on the other homes that you have looked at.
Since most Realtors represent either the buyer or the seller they are trying to get the best deal for each client. This opposing tension tends to lessen the likelihood of a surprise low appraisal. If the home is priced at the high end of the market, a good buyer’s real estate agent will point this out to the buyer before an offer to purchase is made. They will, in turn, present data to the seller and listing agent supporting their belief that the home is overpriced. This may not persuade the seller to lower their price but at least the buyer and seller won’t be surprised if the home doesn’t appraise for the sales price. If you are purchasing a home you can have your contract include a clause that the home must appraise for the sales price or you have the option of voiding the contract and having your deposit refunded.
Sometimes buyers will agree in advance to purchase a house even though it didn’t appraise for a higher sales price. A purchase agreement clause agreeing to do this sometimes is needed to beat out other offers on a particularly popular home. A good Realtor can provide you with suggestions for this.
Appraisals are not meant to squash someone’s plans for home ownership and low appraisals are rare. They are also not an exact science. I have seen appraisals on the same house vary by thousands of dollars. They are simply an analysis of the home used by the lender to get to know what type of collateral they are lending on. Since the home is the collateral for the loan, the lender wants to know that the collateral is of sufficient value to protect the amount of the loan. Lenders are required to provide you with a copy of the appraisal for you to review and keep for your records.