When you get a loan on a house, most lenders will require an appraisal. An appraisal is a report that values the home and tells the lender that the house is worth what you’re paying for it. If the appraisal comes in lower than the contract price or the appraiser requires repairs to be made, it can kill a deal and cause a lot of frustration. Appraisals and the guidelines appraisers must follow can also be very confusing to people who are not familiar with them. I hope this article can shed some light on what appraisals are and how they are completed.
Why do banks require appraisals?
Banks and mortgage companies love to lend money on houses, because houses are a more secure debt than cars or businesses. If the borrower defaults on a house the bank can foreclose on the home and take possession. However, foreclosures are not cheap to complete for the bank after you factor in paying the attorneys, selling costs and lost interest. To reduce the amount of money a bank loses from foreclosures they first want to lend money to qualified buyers and second the bank wants to make sure any house they lend on is worth what the borrower is paying.
If banks did not confirm values the borrower could buy a house for $50,000 more than it is worth. If the home was foreclosed on the bank would not only lose money on lost interest, selling costs and attorneys fees, they would have to sell the house for $50,000 less than they thought it was worth (assuming prices did not go down since the loan was made).
An appraisal is done by a licensed appraiser and is meant to confirm the amount the buyer is paying for the home is at least as much as the home is worth.
What is an appraisal?
An appraisal is a valuation of a home or property and is done by a licensed appraiser. I complete many broker price opinions (BPOs) as a real estate agent, but a BPO is not an appraisal and not as detailed. BPOs are used to determine market value for banks who may be trying to complete a short sale or for banks who need to know the value of homes that are going into or have been foreclosed on. BPOs are not used to determine the value of houses for new loans.
To complete an appraisal the appraiser will view the entire home, take pictures, measure the house, inspect the condition of the house, and complete a report that values the home. The report consists of sold comparables, which are houses that have sold recently and are the most similar to the house being appraised (subject home). The appraiser has certain guidelines they should follow regarding the comparables that are used to value a house. Sold comps should:
- Have sold in the last six months.
- Have above ground square feet within 20 percent of subject.
- Have similar basements (finished or unfinished if applicable).
- Have been built within a certain time frame of the subject (usually ten years)
- Be in similar condition as the subject.
- Have similar bedroom and bath counts.
- Be in the same neighborhood or within a certain distance of subject (usually one mile).
If there are not enough sold comparable properties to meet all these guidelines, the appraiser can expand his criteria and make adjustments. If a house is in a rural area than the appraiser may have to look within ten miles of the subject for comps or look for homes within 20 years of age, because there are no other comps. When an appraiser makes adjustments they will add or subtract value from the comparable properties for different characteristics.
How do adjustments work on an appraisal?
When an appraiser uses comparables that are different from the subject the appraiser has to subtract or add value to the comp. If a comparable sold for $150,000, but is superior to the subject by $10,000 then the comparable value would be $160,000. On the report the $160,000 adjusted value of the comparable would indicate the subject house is worth $160,000. To come up with adjustments the appraiser will compare the important characteristics of the subject and comparable sales (usually at least three comp sales are used). If the subject has 3 bedrooms and the comparable has 4 bedrooms, the appraiser may deduct $4,000 from the comparable because it is superior to subject. If the comparable characteristic was inferior to the subject then the adjustment would be positive.
Below is an example of some adjustments that might be used by an appraiser:
Subject Comparable Adjustment to Comp
1,500 SQFT 1,700 SQFT -$6,000
3 bedrooms 4 bedrooms -$3,000
2 baths 3 baths -$2,500
2 car attached garage 1 car attached garage $4,000
1,000 SQFT unfinished basement no basement $7,500
Built 1979 Built in 1988 – $5,000
Total adjustment -$5,000
If this comparable home had sold for $150,000 then the adjusted sales price used to value the subject would be $145,000. The appraiser would then do the same thing with at least two more sales comps and come up with a value for the subject using these values.
Do appraisers use active comps in appraisals?
One frustrating aspect of appraisals is appraisers will primarily use sold comps to value a house. Sold comps must be used because you can list your house for whatever price you want, but you won’t know what it is worth until it sells. If an appraiser used active comps to value homes the value could vary greatly based on if the asking price is close to what the home is really worth. An appraiser may use an active comp once in a while if there are very few comps available to help justify value. The active comp is used to supplement the sold comps not be the primary focus.
What happens if an appraisal comes in less than the contract price?
Banks want the appraisal to come in at or above the contract price to confirm the value of the home they are lending on. Banks will lend on many different loan to value ratios. Some loans like VA require zero down, while others like conventional investor loans with require 20 or 25 percent down. The bank will base the loan to value ratio on the lower of the contract price or the appraisal. If the contract price is $100,000, but the appraisal comes in at $90,000. The bank would base the loan amount on the $90,000, not the $100,000. With a 20 percent down payment the loan amount would be $72,000, instead of $80,000 in this scenario. With no money down the loan amount would be $90,000, instead of $100,000.
As you can see the appraised value can greatly affect many buyers ability to buy a home and the money they need to purchase the home. Low appraisals have killed many deals when the buyer was not willing to bring more money to closing or the seller was not wiling to lower the price.
How can you deal with a low appraisal?
If an appraisal comes in low you can challenge it, but the appraiser may not change his value. I am going to talk more about challenging appraisals in an upcoming article. Be sure to subscribe to my blog to get notified when that is published. The lender can help you challenge an appraisal, but usually there has to be a gross miscalculation or mistake on the report for the appraiser to change his value. You can also do a few things to help appraisals come in at value before the appraisal is completed, which I will also talk about in the new article.
If you can’t get the value changed the buyer will have to bring more money to the closing table or the seller will have to reduce the price. Sometimes a combination of the two or the real estate agents reducing their commission may make the deal work. If the two sides can’t come together on price a second appraisal may be done in some circumstances, but you would have to talk to your lender to see if that is a possibility.
Do FHA appraisals stick with a home?
When a buyer uses a conventional loan to buy a house, the lender will get a conventional appraisal done. If the conventional appraisal does not come in at value a different lender can order a new conventional appraisal, which may come in at value. If the buyer is using a FHA loan the appraisal sticks with the home. That means for 4 months any FHA loan will have to use that same appraisal. If a FHA appraisal comes in low on a home and the sellers will not reduce the price, then the sellers will most likely not be able to sell the home to any other FHA buyers for at least four months (unless they lower the price to the FHA appraisal amount).
In some cases a lender will also require that two appraisals be done. I flip many houses and lenders get scared because the price I sell houses for is much more than the price I buy houses for. When the lender or underwriting sees a huge price difference they usually want a list of the repairs I made and a second appraisal to confirm the value.
Why are appraisal guidelines so strict and why do appraisals come in low?
A few years ago the United States went through a massive housing crisis. Much of the housing crisis was caused by inflated values and some of those values were high due to lender fraud. In my town of Greeley Colorado we had a few instances of fraud.
- Builder builds a home
- Realtor for builder finds unknowing buyer and promises low payments ($500 on a $250,000 purchase)
- Realtor, builder and lender all convince buyer to use a risky ARM loan where payments will more than triple in one year (many times the buyer does not know how much more the payment will be).
- They all sell the home for at least 20 percent more than it is worth and buyer agrees because of low payment.
- Appraiser is in on the fraud too and inflates his appraisal to confirm the value.
In a couple of cases like this hundreds of homes went through foreclosure and many people went to jail. In order to stop this type of fraud from happening again appraisers were scrutinized for any values that may appear high. A few things appraisers learned to avoid in appraisals to avoid scrutiny are:
- Mentioning a rising market for prices, because this could justify higher values
- Coming up with a value higher than any sold comps
- Using active comps to value a home higher
Basically anything that could be a judgement call to raise appraisal values is avoided by appraisers, because they don’t want to be investigated for fraud. This makes it tough on buyers, especially in a rising market because the sold comps may not be as high as their contract price.
What if an appraisal requires repairs to be made?
A low appraisal value can mess up a house sale, but an appraisal can also call out repairs to me made. On most loans the lender will require a home to be in livable condition. That means all the major systems must work; plumbing, heating, electrical, roof, sewer. The appraiser will also make sure there is nothing dangerous like peeling paint (could be lead-based paint and poisonous), holes in the walls, floors, broken windows or mold.
If you are trying to sell or buy a house that has any of these issues, the appraiser may require them to be repaired before closing. The seller could have the items repaired or in some cases the buyer may be willing to make the repairs before closing (on REO and HUD homes it is usually not an option for the buyer to make repairs). If the seller can’t or won’t make repairs the deal will usually die and the house will have to be sold with a loan that does not require repairs or for cash.
Unlike an inspection, the seller cannot simply agree to lower the price in lieu of making the repairs. The lender and appraiser will require the repairs be made before closing, unless the repairs can be escrowed. I will talk more about how to escrow repair items in the next article as well.
Appraisals can be a huge pain to buyers and sellers when they come in low or require repairs. However, they are necessary for sellers who want to get the most money for their houses or buyers who want to get a loan. If you run into a problem with an appraisal there are many things you can do to keep the deal in place which I will discuss soon.