Appraised value doesnt necessarily equal market value

Prior to funding a loan, nearly every mortgage lender requires some type of property appraisal.3 To the detriment of their borrowers, lenders often play games with appraisers and appraisals. Understand that the lender's appraised value for a property can register above or below the property's market value. Moreover, neither appraised value nor market value says anything about the price you should expect the property to sell for in the future.

Credit, Not Property

For most mortgages on one- to four-unit residential properties, credit stands more important than property (Secret #40). To see how this fact applies to appraisals, let's eavesdrop on this conversation between a loan rep and an appraiser.

3 Some streamlined refis omit this step. The topic of appraisals is discussed more extensively in my books, Investing in Real Estate, 5th ed. (John Wiley & Sons, 2006); and The 106 Most Common Mistakes Homebuyers Make (and How to Avoid Them), 4th ed. (John Wiley & Sons, 2006).

"Hello, Ed, this is Frank over at Fidelity Mortgage. Look, we got a borrower with a 790 FICO. He wants a $640,000, 80 percent LTV loan to buy an $800,000 place in Mountview. The price sounds a little steep to me, but we would really like this loan to go through smoothly. See what you can do for us, okay?"

"Sure," appraiser Ed responds, "fax the appraisal order to us. I'll get on the job right away. Sales price does seem on the high side, but those homes in Mountview have been appreciating pretty well. I think I can come up with some comps. With a little fiddling, I suspect that we can get the number you need. I'll get back to you in a few days. And thanks again for your business. This will make the fiftieth appraisal job our firm has performed for you this year. Let's hope the market continues to roar."

Strong Borrowers Generally Get the Appraised (i.e., Appraiser) Value Lenders Want

You pay for the appraisal report, but you're not the client. The lender is the client. No appraisal firm that wants to stay in business can regularly provide value estimates that run against its lenders' wishes. That's why the appraisals for strong borrowers nearly always equal or exceed their purchase contract price.

Don't conclude that you're protected by the lender's appraisal. Do your own research. Satisfy yourself by expertly comparing properties, features, and sales prices. Some homebuyers fall in love with a property, agree to pay whatever price the seller is asking, and expect the lender's appraisal to bail them out if they've overpaid. Unless for some reason the lender wants to kill the deal, that won't happen. For the great majority of owner-occupied purchase/refi loans, credit trumps valuation, rarely the reverse.

(For subprime loans, lenders do reduce credit standards, but to offset risk, they set lower LTV ratios and/or greatly increase points, fees, and interest rates. Nevertheless, loan reps will still push appraisers to hit the value required to fund the loan.)

Electronic Appraisals

Increasingly, for high credit score borrowers, lenders may not even send an appraiser out to the property. Instead, they obtain the appraisal electronically from a data bank of recent property sales. If your contract price doesn't severely raise eyebrows, the property passes the appraisal test. Although appraisals based on statistical modeling have long been used by property tax assessors, they do not adequately substitute for close, detailed property appraisals performed by a competent and disinterested expert.

I have run dozens of properties through software valuation models. The results provide a basic data point, but I never rely on them as a final answer. Errors abound.

From a cost standpoint, though, electronic appraisals win hands down. A typical price for an electronic appraisal ranges from $3 to $15 versus the $250 to $450 that most appraisal firms charge. At sites such as zillow.com, you can even pull up free comp sales and value estimates.

If your lender does use a computerized appraisal, watch out for over-billing. Some lenders go ahead and bill you at closing for a standard appraisal fee. HUD says these types of markups (garbage fees) are illegal, but federal courts have ruled otherwise.

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