Home Appraisal | Mortgage Process Explained
After you give the lender your intent to proceed they’ll order your home appraisal. This is a critical (and potentially frustrating) step in the home buying process. Let’s break down the entire home appraisal process, why it matters for the mortgage lender, and what it means for the home buyer and seller.
What is a home appraisal?
An appraisal is an assessment of how much the home is worth. These assessments are done by a licensed professional – you pay them a fee and they inspect the property. The appraisal is done by an unbiased, neutral third party with no affiliation to the seller, the lender, or you – the buyer. Because the appraiser must be neutral, you do not choose your appraiser and you do not pay them directly. The mortgage lender will hire the appraiser and collect the payment directly from the buyer as part of the loan process.
When assessing a home, appraisers look at the neighborhood, neighboring home values, and the condition of the property. The appraiser usually has the title report – a description of the home and how it has changed over time. As owners make improvements to the home, they pull permits, and those changes will be reflected on the title report.
The appraiser will inspect high and low – they will check the foundation, walls, roof, plumbing, electrical, windows, doors, you name it. They will find issues, especially in older homes. You can see our full home inspection checklist that includes a sample appraisal report. But there are some common issues that will jump out –
- Cracks in walls, ceiling, or foundation
- Water leaks or suspicious moisture
- An old roof – if the roof looks like it will need replacing within the next few years the appraiser will make note.
- Lead paint – if the home was built prior to 1978 there’s a good chance there is lead paint somewhere.
- Un-permitted addition – This is really common in some areas in Los Angeles, San Francisco, and other older cities that expanded quickly. If major changes were made (say the current owner added a bathroom) and permits were not pulled, this can be a red flag. The home won’t match the title report, which means the changes were never filed with the city or inspected. If the changes were not done to in compliance with local building codes, and your home gets inspected by the city or the county, you may be required to bring the work up to par. This means paying for permits, hiring a contractor to make fixes, or potentially tearing the addition down. You can learn more about un-permitted work here.
Pro tip: Your appraiser won’t report work done without a permit to the city. But you know who may file a complaint? A disgruntled neighbor. They may have lived next door when the work was done, but they were chummy with the owner so they never did anything about it. If you move in and are “less than neighborly,” they may call the relevant authorities and report you – causing a big, expensive headache.
There are a few different appraisal methods, but for residential real estate the appraiser will probably use the sales comparison approach. Like your realtor did when they helped determine your offer price, the appraiser will pull comparable home sales in the area. After the appraiser does their inspection they’ll make a list of all the issues they found. They’ll also make a list of any bonuses (new roof, updated plumbing, solar panels, backyard pool, etc.) They will take those comps, make adjustments based on their inspection, and come up with what they think the home’s fair market value is.
How does the appraisal affect my mortgage?
The appraiser’s estimated value is a big deal for a few reasons. It has the potential to be different than your offer price. If your offer price is lower than the appraised home value you’re set – you negotiated a good deal. The seller may have actually been able to sell for more money, so you should be excited.
However, if your offer price is higher than the appraised home value this can create issues. First and foremost, you may feel like you overpaid for the home. Obviously this is not a great feeling, but don’t play this game with yourself. The seller may not have sold to you at the lower price. If you felt good about your offer and you can afford the mortgage payment, the home is worth only what someone was willing to pay for it.
The problem is, the lender does not see it this way. They base their LTV ratio on the lesser of the appraised value and your offer price. So if the appraisal comes in lower than your offer price, there is a decision to be made.
Let’s consider a scenario – Say you offered $250,000 to buy a house. You are putting $50,000 down (20% down payment) and were getting a loan for $200,000. $200,000/$250,000 gives you an 80% loan-to-value ratio. Now say the appraisal estimates the home value at $240,000, or $10,000 lower than your offer price. That will force you to pursue a few different options…
Get a second appraisal
This is the path of least resistance here. Your loan officer and realtor can advise you on whether or not this is something worth pursuing. Sometimes appraisers rush through the process, use a weird valuation method, or pull comps that were old or just not as relevant as other available comparable properties. Getting a second appraisal can cost you money and delay the timeline, but if the second appraisal comes in at the right number this is by far your best option. But beware – the second appraisal could also come in lower than the first, and then you’re in a real pickle.
Renegotiate the purchase price
This can be rough. If you have an appraisal contingency in your purchase contract you have some leverage. If the seller doesn’t work with you to renegotiate the price, they have to re-list their home, and the delay in selling might be a serious wrinkle for them (especially if they’re buying another house at the same time.)
If you don’t have an appraisal contingency in your contract you’re in a tight spot. The seller doesn’t have to renegotiate with you, and if you can’t complete the home purchase, you’ll lose your earnest money deposit. This is one of those areas where having an experienced real estate agent can save you.
Increase your down payment to keep the same loan
If that appraisal says the home is worth $240,000, suddenly your $200,000 loan is 83% of the home value. This adjustment will change the terms of your loan, and in some cases could keep you from qualifying.
To get your loan back to that 80% LTV, you’ll have to reduce your loan amount to $192,000 – an $8,000 difference. Your monthly payment will actually go down in this scenario, but you will have to come up with that $8,000 in cash to close the loan.
Change your loan product
If you don’t have the cash to make up the difference you may have to adjust your loan. Even though your loan amount hasn’t changed, the increase in your LTV ratio can lead to a higher interest rate, a higher monthly payment, and more cash to close. This is especially true if you have to pay for mortgage insurance now.
The other thing that sucks is lenders see this new scenario as a different loan – you’ll even get a new Loan Estimate. If you already locked your rate, it might not be applicable anymore. If interest rates went up since you locked, you get burned here.
The most painful decision, but sometimes the right one. Maybe you can’t hustle up the cash to close, or you can’t afford your new, higher monthly payment. Or maybe you can afford both of these things, but you decide it’s just not the right financial decision. In this case, it just wasn’t meant to be. Chalk this up as a learning experience & work with your real estate agent to get your earnest money back.
Avoiding issues with your home appraisal
As you can see, getting the home appraised at the right value is a big deal. The worse part about it is getting the appraisal is not a quick process – once the appraisal is ordered you’re in for a week of anxiously awaiting your fate. Here are 3 steps you can take early on to reduce your stress during the appraisal process –
- Make sure your offer price is in line with the market – This is hard in a hot market where logic can go out the window. But you need to be disciplined. Know the comps you are using to help craft your offer price & ask questions about them. How old are they? How similar are they? What adjustments were made? If your offer price is significantly higher than the comps you’re setting yourself up for failure, or at the very least a big headache.
- Put contingencies in your offer – Having home inspection & appraisal contingencies in your purchase contract gives you far more leverage. If the appraisal comes in low, you eliminate the possibility of a stingy seller who refuses to work with you and then pockets your earnest money.
- Build your cash reserves – Cash is king. It buys flexibility. When crafting your offer (or even when calculating your home affordability), assume some wiggle room in the appraisal value. Figure out what your cash to close would be if the home appraised 5% lower than your purchase price. Have that cash set aside in your house fund – if the home appraises low and you still want to move forward you’ll be prepared. If you never end up using your reserves you will have cash ready for home maintenance expenses, remodeling expenses, or an emergency fund.