In this week's Real Estate Tip of the Week, I discuss why home appraisals are performed and what you as a buyer/seller should know about them. To start, a home appraisal is an unbiased estimate of a home's market value. They take place in the home buying process when a buyer uses lender/bank financing to buy a home. Since most people don't have enough money to buy a home outright, appraisals occur in almost all residential real estate transactions. Lenders require home appraisals to be conducted by a licensed Appraiser because they want to make sure the home is being bought at its market value. This is important to them because if the buyer defaults on their mortgage payments, the lender will be able to recover their money. Appraisals typically take place at the buyer's expense ($400-$600 in Northern Virgina). Licensed Appraisers determine a property's market value by evaluating recent sales of similar properties in the area and the property's current condition. The home appraisal contingency is a typical contingency in a residential sales contract. Basically, the contingency protects the buyer if the home is appraised for less than what it is being sold for. If that happens, the buyer and the seller have to come to an agreement to make up the difference. Either the buyer can put up more money, the seller can lower the sales price, or a combination of both can happen to cover the difference. If the buyer and seller can not reach an agreement, the buyer can use this contingency to cancel the purchase contract. On the flip side, if the property is appraised for more than what the sales price is, then that indicates the buyer received a good deal and has a lower LTV (Loan to Value) Ratio.
For example, if a buyer puts $40,000 down to buy a $200,000 house, the LTV Ratio would be 80% ($160,000 loan / $200,000 house = 80%). If the house was then appraised for $180,000, the LTV Ratio would be 89% ($160,000 loan / $180,000 = 89%). Therefore, the buyer and seller would have to come up with $16,000 to bring the LTV Ratio back down to 80% ($144,000 / $180,000 = 80%). This difference has to be made up because the lender's loan to the buyer is based on the original LTV Ratio.
Finally, I want to add that the buyer's lender is very important when it comes to the home appraisal. The lender typically picks the Appraiser and that can have a huge impact on the appraised price. Larger banks can choose an Appraiser who is unfamiliar with the area and therefore, might not appraise the home for its true market value. An Appraiser from Bethesda, probably won't be as accurate as an Appraiser from Arlington when appraising an Arlington home. Thus, it is very important to choose a lender that you can trust and one that works with local professionals. It will save you the hassle and stress of a transaction that never reaches settlement.
To learn more about the buying process, check out my Buyer's Guide. To learn more about the mortgage process, check out my Mortgage 101 page.