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.