So you made an offer on a house, the seller accepted, and now, like nearly half of all Americans, you need a mortgage to make that house your home. Well, there’s one more step that has to happen before you can get a mortgage--the appraisal.
An appraisal, which differs from a home inspection, is an objective, professional estimate of a home’s market value. It is determined by a trained, licensed or certified appraiser who evaluates the home inside and out and establishes the home’s value based on a number of factors, including location, condition, renovations and amenities, comparable homes in the area, and the current market.
The appraisal is required by the buyer’s mortgage lender and is paid for by the buyer. The fee depends on the home’s size and value but typically costs under $500. The most common type of appraisal for single-family homes is the Uniform Residential Appraisal Report (URAR), which is an official report put together by the appraiser after analyzing the property in person.
The appraisal, in addition to your own finances, determines how much the mortgage lender is willing to loan you and factors into your loan-to-value ratio (more on that later). It protects both you and the lender by keeping you from over-borrowing and keeping the lender from over-loaning beyond what the house is worth.
The appraisal may differ from the selling price, which could affect your purchase of the home and your mortgage. The mortgage lender will only approve a loan based on the appraised market value (not the selling price) because they need to ensure that they can get that money back in the event of a foreclosure. So let’s break it down into a real-life scenario. Let’s say the sale price of your dream home is $500,000, but the appraisal comes in at a value of $450,000. That means the mortgage lender will only give you a mortgage based on the $450,000 value.
A home’s value and its selling price are two different things. The price is whatever the home sells for, but the value is determined by the appraiser. I can sell you a candy bar for $15 if you’re willing to pay that, but it is really only worth $1. The same applies to buying and selling homes. The seller wants to sell a home for as high a price as possible, regardless of its value. But the value is what matters to the mortgage lender because that is what your loan is based on.
If the appraisal is higher than the selling price, then congratulations, you’re getting a great deal by paying less for a home that’s actually worth more! This scenario has no impact on your mortgage.
If the appraisal is lower than the selling price, you can still get a mortgage, but it changes things a bit. Remember that your mortgage is based on the home’s market value, not the selling price. So, in the above case, if you purchase a home for $500,000 with an appraised value of $450,000, you will be responsible for the difference, which in this case is $50,000. But you also have other options. You can appeal/ask for another appraisal, you can walk away from the sale altogether (with an appraisal contingency clause in your purchase agreement), or you can use the appraisal to try to negotiate a lower sale price.
The loan-to-value (LTV) ratio tells you how much of your home’s value you are borrowing. It’s important because it affects your interest rate, your monthly payments, your closing costs, the kinds of loans you are eligible for, whether or not you need to pay for private mortgage insurance (PMI), and your likelihood of getting approved for a loan. In the case of your LTV ratio, the lower, the better. This ratio is important not just for buying a home but also for refinancing.
The appraisal is integral in determining the LTV ratio. The LTV ratio is calculated by dividing the mortgage amount by the appraised value, and that number is the percentage of the home’s value that you are borrowing. The more equity you have in the home (in other words, the more money you pay upfront in your down payment), the less money you are borrowing from the lender.
So, let’s continue with our previous example of the home valued at $450,000. Since the lender will only give you a loan based on the appraised market value, you already know that you are responsible for paying the difference between the value and the sale price. With that out of the way, you now have only the $450,000 value to focus on. Let’s say you can afford to pay another $50,000 in your down payment. This is your own money that you are not borrowing, so that brings the mortgage amount down to $400,000. The LTV ratio (400,000/450,000) comes to .888, meaning you are borrowing 89% of the home’s value. A high LTV ratio such as this brings with it more risk to the mortgage lender and, therefore, higher interest rates, higher monthly payments, and higher closing costs for you. In addition, with an LTV ratio above 80% (meaning you paid less than a 20% down payment and therefore have less than 20% equity/ownership in the home), you may be required to buy private mortgage insurance, which protects the mortgage lender should you default on your loan.
Buying a home is a major life event, and we want you to be in yours for a long time to come. Now that you are armed with the knowledge and understanding of the appraisal process and how it impacts the purchase of your home, we hope you can feel confident that you are making the right decision for you and your family. If you have any questions about your loan or the mortgage process, the team at Ruoff Mortgage is here to help.
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