Three Blunt Truths About Appraisals when Getting a Mortgage

Note:  This is a chapter in my new ebook called The Ultimate Guide to Buying (and then Selling) Your First Home.  I will post a chapter a week.  If you like what you read, you can pick up a copy here for the price of a candy bar!   Buy a candy bar or be a real estate guru!   This chapter discusses appraisals and why they are needed.  Appraisals can be confusing especially when they come in lower than the sales price.  The last chapter to be shared on this blog you can find here

Steve and Sally emailed me the next day asking if an
appraisal was something to be concerned about with the home they were
purchasing.   I reminded them that as a first-time
home buyer, there are things along the way to buying your first home that can
quickly put a stop to getting the home.  
We had already gone through how to negotiate for the right price for
your home as well as what it takes to get it inspected.   The repair amendment can be one of the most
stressful step in the process as you attempt to get the seller to make some
repairs and we made it through that step smoothly.   I continued in my email “The next step in
the process is that your mortgage company will hire an appraiser to determine
the value of the home.  The lender needs
to know that the loan being provided to you can be recovered when selling the
home if the need should ever arise (such as they must foreclose on the
house).   Lenders will never loan you
more money than what the house is worth.  
Here are three blunt truths about the appraisal you need to know when
getting the house appraised. “

1.   Appraisers Distinguish Between Value and Price
–  I wrote, “Believe or not, there is a
very big difference between the price of a home and its value.”   I quoted one of appraiser defines the
difference in the Real Estate Appraisal Principles and Procedures.   (http://www.amazon.com/Appraisal-Principles-Procedures-Edition-Messick/dp/B00DT68OLO)

Value refers to what a piece of property is theoretically
worth under certain circumstances.  
Price on the other hand, refers to the actual amount paid by a
particular buyer to a particular seller in an actual transaction. I explained
further in the email.  “From the point of
view of the lender, the one they are concerned about is the value.  Why is that since you are willing to pay the
price you agreed upon with the seller?  
A lender is worried about the value because what it can theoretically
get for the home translates into what they can recoup for their investment into
the home.   Another way to look at it is
that the price you are paying for the home means very little to the lender
because they only want to know what they might get for the home at a future
date.   In many markets, you will see
homes that go far above asking price of a home which means the mortgage company
will probably not cover the entire price paid for it.   What do you in this case?   Read on!”

2. Appraisals must
match the agreed upon sales price
– I continued in the email. “If the value
of a home is appraised differently than the price being paid for a home, there
are some considerations you will have to make.  
If the value is higher than the price, you are good to go. You will even
have some equity in the home when you initially buy it so good for you!   If the value is lower than the price, you must
figure out a way to make up the difference between what the lender will give
you as a loan (value) and what you are willing to pay for it (price).   Many buyers will just pay more down to cover
the difference, but some buyers are not in a position to do this.   In this case, you will have to negotiate
with the seller to possible lower the sales price to match the determined
value.   You can visualize how the seller
will feel.  They will be asked to give up
some of their profits to sell the home to you. 
Most sellers will not move on this as they feel they can get the same
price from another buyer.   A third
option would be to meet in the middle where the sales price is dropped, and the
buyer puts more money down.  No matter
what option is chosen, it will be a difficult pill for either side of the
transaction to swallow.   Does this
happen often?   It depends on the
market.  If it is a seller’s market where
homes are few and far between, many buyers will find themselves offering above
asking to get the house.   In these
cases, you will often see a home appraised lower than the sales price because
it takes time for value to catch up with the quickly moving market. “

3. Appraisals are
Subjective to each Appraiser
.  I
finished my email with one last fact about appraisals that no one likes to
admit.   “In the book quoted before, the
authors go into some details about the steps necessary to take to appraise a
home.   It is a structured process that
each appraiser will take.  They must
define the appraisal problem including the type of property and what is being
asked to be appraised.  A preliminary
analysis will be done to chart a course forward.  The appraiser will then collect data by
looking at the site and seeing what has sold recently in the area.   They will then look at the property from the
three different approaches of value (sales comparison, income approach and the
cost approach).   They will reconcile the
different values realized and then draw up the report for the lender.   Appraisals have had to become this
structured in the late 1980s when some bad appraisals lead to a major financial
crisis (Savings and Loans Crisis).  
Despite all of this process, it ends up that appraising a property can
be more of an art than a science depending heavily on the subjective viewpoint
of the individual appraiser.   To help
battle this subjectivity, we will work with the listing agent to communicate to
the appraiser how the sales price was determined.  An appraiser is not required to take this
information, but more often than not, they will do so.  One trick is to leave a packet of information
behind for the appraiser, who can take it to help to determine price.  It should be noted that agents must be
careful not to be too aggressive in their communications with the appraiser,
taking a more suggestive approach as some appraisers find the agents
involvement to be undue influence in their decision making and will not
tolerate it.   Finally, appraisals can be
appealed but very few are often changed.”

I got an almost immediate response from Sally, thanking me
for the in-depth tutorial.  She said she
would be keeping her fingers crossed that the appraisal will come back as it
should.  . A week later, I received a
phone call from Steve and Sally’s lender. 
He said that they had gotten the appraisal back and it was $172,000,
which was below the sales price by a $1000. 
All was good, however, since they had put so much down on the property
(25%), Steve and Sally already had enough cash on the table to make up the
difference.  Steve and Sally were very
happy to hear the news, but a bit confused by why they didn’t have to come up
with another $1000.   I laid it out for
them over the phone.  “You put down 25%
of the sales price in cash, which came to $43,250.  You then asked the lender for a mortgage of
$129,750.  The loan to value ratio of the
loan was 80% so you only needed to put down $34,600 to qualify for a home
valued at $173,000.   The appraisal came
back one thousand dollars less than the sales price, but because you had
already put down $9,000 more than needed to qualify for the mortgage, the
lender is fine with the lower appraisal. 
The only time you would have needed to add additional funds to your down
payment is if the property value had come back at $164,000 or less.”   I went on to tell the couple that the
appraisal really hurts with buyers who have very limited funds for a down
payment because they can only provide the minimum amount needed to
qualify.   Steve and Sally responded that
it all made sense now and they were glad they had saved up more than they
needed.    I congratulated them on making
it over this step in the process.  I made
an appointment to meet with them over coffee the next night as I had a
“lecture” I wanted to give them.