How Does an Appraisal Affect a Mortgage?

A real estate appraisal is an objective assessment by a licensed appraiser to determine a property’s current market value. For mortgage transactions, lenders require an appraisal as a security measure. It ensures they do not lend more than the home is worth, protecting both the borrower and the lender by verifying the property’s value, which acts as collateral for the loan.

The Appraisal Process

The appraisal process begins when a lender orders the valuation, usually after a purchase agreement is signed or a refinance application is made. A state-licensed or certified appraiser, a third-party professional with no connection to the buyer, seller, or lender, is assigned to the property. The appraiser schedules a visit to the home to conduct a thorough inspection of its interior and exterior. During this visit, the appraiser evaluates the property’s condition, size, layout, and features, such as rooms, structural integrity, and improvements.

Following the physical inspection, the appraiser conducts research into comparable sales in the local market. These are recently sold homes that share similar characteristics with the subject property, such as location, size, age, and condition. The appraiser analyzes this sales data to arrive at an estimated market value. This analysis, which also considers neighborhood characteristics and current market trends, forms the basis of the appraiser’s final valuation report.

Appraisal Value and Mortgage Approval

The appraised value influences the mortgage loan amount a lender is willing to provide. Lenders base the loan on the appraised value, not necessarily the purchase price, because the property serves as collateral for the mortgage. This protects the lender from financial loss if the borrower defaults, as they would need to sell the property to recover their investment. The loan-to-value (LTV) ratio, determined by dividing the loan amount by the property’s appraised value, is a calculation lenders use to assess risk.

Lenders approve a mortgage based on the lower of the appraised value or the purchase price. For instance, if a home is purchased for $300,000 but appraises for $290,000, the lender will use $290,000 as the basis for the loan. A common LTV requirement is 80%, meaning the borrower needs a 20% down payment to avoid private mortgage insurance (PMI). If a borrower seeks a $240,000 loan on a home appraised at $300,000, the LTV is 80%, which is favorable. However, if the appraisal is lower, the LTV can increase, potentially requiring a larger down payment or incurring PMI.

Addressing Appraisal Outcomes

Appraisal outcomes have distinct implications for the mortgage transaction. If the appraisal matches the purchase price, the loan process proceeds smoothly. The lender finalizes the mortgage based on the agreed-upon terms, confirming the property’s value aligns with the amount being financed.

When the appraisal exceeds the purchase price, the buyer acquires the home for less than its estimated market value. While this provides immediate equity, it does not increase the loan amount beyond the agreed-upon purchase price. The lender’s loan remains based on the purchase price.

If the appraisal comes in lower than the purchase price, the lender will only finance up to the appraised value, creating an “appraisal gap”. The buyer then has several options: pay the difference in cash, increasing their down payment. Alternatively, the buyer and seller can renegotiate the purchase price to match the appraised value or agree to split the difference. If no agreement is reached and an appraisal contingency exists, the buyer may withdraw from the deal without losing their earnest money.