There are so many factors that go into finalizing a mortgage for a home purchase. Aside from the obvious factors – such as your credit score, income, and down payment – the house itself needs to pass the test in order for your lender to agree to provide you with a mortgage.
But what does your house have to do with securing a home loan? Shouldn’t it all come down to your finances and how you qualify as a potential borrower?
While your financial health plays a critical role in the mortgage approval process, that’s not all that lenders want to see. Lenders will also want to have the home checked out in great detail to make sure that what you’ve purchased is really worth what you’ve agreed to pay for it.
In order to do that, an appraisal will be required.
What is an Appraisal?
The purpose of an appraisal is to accurately assess the true value of a property based on current market conditions. It’s conducted by an unbiased third-party appraiser who has been formally trained to carry out such appraisals and makes use of standard criteria that helps the appraiser determine the current value of a property.
With an appraisal in hand, lenders will be able to make a more informed decision about whether or not to approve an applicant for a mortgage. This information will help make sure that the lender is making a sounding lending decision and is not loaning out more money relative to what the property is worth.
The criteria involved can vary from one lender to the next but are typically quite similar. They involve a careful assessment of a property’s physical characteristics, an evaluation of the temperature of the current housing market, and a comparison of the subject property to similar properties in the area that have recently sold. Both the interior and the exterior of the property will be carefully examined.
Are Appraisals Mandatory?
In the majority of cases, lenders will require a home appraisal before approving a mortgage. Several factors influence a lender’s decision to either approve or reject a mortgage application, and the loan-to-value ratio (LTV) is one of them.
An LTV represents the loan amount relative to the value of the home. Ideally, lenders prefer to see LTVs on the lower end of the scale. A higher LTV is more of a risk to lenders because more money must be loaned out relative to the property value.
For instance, a $400,000 loan on a home that’s been appraised at $500,000 would result in an LTV of 80% ($400,000 ÷ $500,000). As an LTV increases, so does the risk for the lender. If the borrower ever defaults on the mortgage at any time, the lender would be out a lot of money if the home forecloses. In order to offset this risk, most lenders require that private mortgage insurance (PMI) be paid if the LTV is over 80%.
The only way to accurately calculate an LTV is to have a home appraised. Without a formal appraisal, lenders would not have an accurate and current property value to work with in order to calculate an LTV. Again, the LTV will help lenders make a decision about whether or not to approve a mortgage, and an appraisal will help them with this.
That said, appraisals might not necessarily always be mandatory. There may be cases where lenders may not require an appraisal if the LTV is extremely low and there is plenty of equity in the home.
However, even in cases like these, it might still be a good idea to get an appraisal done to verify the actual value of the property, especially if you believe it is worth more than the lender believes.
The Bottom Line
When it comes to mortgages, appraisals are part and parcel of the process. Think about it from the lender’s point of view: would you be comfortable loaning out hundreds of thousands of dollars to facilitate the purchase of an asset that’s not worth as much as what was paid for it? In order to protect themselves, lenders typically require appraisals to help them make better lending decisions. Just be prepared to pay for it, as it’s customary for appraisals to be part of a buyer’s overall list of closing costs.