Appraisal

An appraisal is a lender’s final estimate of the home’s value on a purchase or sale of a home. It is important to a seller and buyer to ensure that the lender will be able to provide a mortgage on the property. It is important to a lender to ensure that in the case of default, they will be sufficiently protected from losses. Generally, this goes off without a hitch, but in weird markets or down markets this step can provide a significant hurdle.

Why are appraisals necessary?

As a secured loan, the home provide the lienholder of a mortgage with protection against default. In case the borrower is unable or unwilling to pay the minimum payment, the lender is entitled to (through a process called foreclosure) claim the property as their own and eventually sell it (usually through either a short sale or an auction). If the property is of extremely low value, the lender may feel that it does not provide enough security in the case of default. If the property, however, is extremely valuable, the lender may be able to extend a loan on favorable loan to less creditworthy applicants.

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Why does it matter for a buyer?

Lenders are trying to mitigate their risk when extending large 30-year loans. Think about it as a lender: you are going to give away six-figures ($100,000+) or more to a lender in the hope/promise that they will pay it back over the next 15-30 years. At such a low interest rate (usually only 2.5%-4.0% higher than federal funds rate), they want to ensure that their risk is as low as possible. If their risk is realized (meaning the borrower is unable to pay) they will need to rely on the asset to pay back their losses. If the chargeoff is very early in the loan, the remaining balance will be extremely high (and this is when most chargeoffs occur). If the underlying asset will recover no money on the secondary market (at auction), then they will take a massive loss. The larger they are able to recover, the more their risk is mitigated AND the more favorable terms they are able to provide.

What does the appraisal entail?

Usually, the appraisal is a pretty low-touch experience. A professional appraiser will generally perform an exterior evaluation of the property and ensure no major damages are not accounted for, such as a failing roof, foundation, or visible signs of damage to the exterior/interior. After this, a generic “comparable test” will be performed, where they will compare the property with similar recent sales in the immediate area: homes that are similar in square footage, number of bedrooms, number of bathrooms in the area. For example, if 3-bedroom, 2-bathroom, 2,000 sqft homes have been selling for $200,000 in the area, it is reasonable to assume that a sufficient quality home with those qualities will get a similar appraisal.

The appraisal is generally meant to ensure that the loan meets certain thresholds (usually loan-to-values of 95%, 90%, 80%) for different interest rate requirements. A Loan-to-value of 80% with a high FICO generally means (not always) that the loan is able to be sold to Fannie Mae or Freddie Mac, which lowers the lender’s risk.

In short, don’t worry about the appraisal. If the home is in decent condition and the offer is reasonable, then the appraisal should be just another step in an easy process to transferring the title of the home.