Mortgage Rates - Why Your Appraisal Can Kill You

Essentially, there are three prices: a list price which is the asking price by the owner of the home; the sales price which is the price of the home on which the seller and buyer agree; and then the appraisal price which is the actual defined value of the home. Of the three, the appraisal price carries the most weight and is the one your lender will use when discussing your mortgage options.

Let's use common sense. If a sales price is high, and the appraisal price low, then a home buyer is purchasing a home for more than its worth. For a lender, he or she is then faced with loaning a portion of the sales price as a mortgage knowing that it poorly reflects the home's true value.

The appraisal value determines your loan to value ratio. If the mortgage loan is based on an inflated sales price compared to a lower appraisal value, the loan to value ratio is said to be high. If the appraisal value is actually higher than the sales price, then the loan to value ratio is deemed low. As the loan to value ratio increases in any given situation, so does your mortgage rate. But why?

If you are a lender, you are taking a risk as you approve a mortgage loan based on an inflated sales price. Let's assume a home is appraised at $100,000, but the sales price is $120,000. The buyer wants an 80 percent mortgage on the home based on the sales price, so the mortgage would be $96,000. The lender however realizes that this mortgage loan is just under the actual appraisal value of the home; so, if the new homeowner should default, there is a good chance (with all the related costs) that the lender will lose significantly.

In addition, the buyer is expecting not to pay PMI (private mortgage insurance) on this loan; but because it exceeds 80 percent of the appraised value (which is $80,000), PMI will certainly be tacked onto his mortgage. When a lender is faced with this situation, and the buyer's good credit and other factors still favor loan approval, the mortgage rate will clearly be higher to help offset the lender's risk.

As the loan to value ratio increases, so will your mortgage rate. If your loan to value ratio declines, your mortgage rate will also. The important thing is to realize this when negotiating a sales price so you can align yourself well when you are ready to finance.

Getting back to Robert, the agreed upon sales price was $300,000, but unfortunately, the appraisal value was only $275,000. Robert however had a clause in his sales contract that allowed him an "out" should the appraisal fall short of the sales price. Instead of walking away, he re-negotiated with the seller, and they agreed upon a new sales price of $275,000. Now the sales price and the value were even.

For many homeowners, an appraisal can be a rude awakening. They may have exaggerated opinions about how much their home is worth. But when the appraisal returns well below the figure in their mind, reality sets in. In today's real estate climate where market prices are rapidly readjusting downward, many homeowners find themselves in this situation.

Indeed the market is clearly a "buyer's market", but beware of a further drop in overall home values if you are trying to make moves in the short term. An appraisal value is based in part on comparable sales in the last 3 to 4 months; so if values continue to decline, you may purchase a home at today's value that in six months is worth less.

Those considering refinancing should act now while they know what the value of their home is. Those buying for speculation should make sure they are buying extremely under market, but those buying to reside in a property today can still take comfort. They are buying when the market is good for buyers. It will be impossible to know for a fact that you are buying at the bottom of the market. Usually, the bottom is only truly known when it is in the rearview mirror and prices have started to increase again. So enjoy buying when the market is in your favor, and get a great deal, but don't sweat if you are timing the market perfectly or not.

No one can accurately predict when your area's home market will bottom out and start appreciating value again, but in negotiating a sales price at or below the appraisal value, you can certainly obtain the best mortgage rate possible for the present.