Whether you are buying or selling a home, the appraisal may be one of those things that can make or break a deal. We've see homes fall out of escrow when the appraisal came in too low.

The bank wants to make sure they get their money back should you walk away from your loan, which means they will not lend more than the house is worth. Your lender will send out an independent appraiser to tour the home, look at major mechanical systems and note the condition and features of the home. They will then check comparable home sales in the area and create their opinion of what the home is worth.

Keep in mind that it's ONE person's opinion of the value of the house, and another appraiser may have a completely different opinion. The industry is not standardized and the list of 6 comparable homes chosen may be different from list you may have chosen. A house is really worth what someone is willing to pay for it, so this archaic system hasn't really kept up with pricing in appreciating neighborhoods or markets.

How does the appraisal affect the purchase or sale of my home?

Buyers: If the appraisal comes back lower than the selling price, the buyer will have to make up the difference. You can either make up the difference in cash, or you ask your lender if you can adjust the "loan to value ratio" of your loan. If you can't do either of those things, then the deal falls through because you can't bridge the gap between the appraised price and the contract price. Your goal is to have the appraisal came back before you need to release your contingencies, and use backing out of the contract as your last resort.

Sellers : The listing agent's end goal is to ensure their client's sale goes through, because a house falling out of escrow is bad for both the buyer and the seller. How does the listing agent ensure a deal goes through?

-They may advise the seller to accept an offer that has enough wiggle room in the selling price in case the appraisal comes in low.

-They may also advise that the seller not accept an offer with an appraisal contingency. With no appraisal contingency, you can't back out of the deal if the appraise comes in low or you will lose your earnest money deposit.

-They may advise that the Seller pick a buyer with enough money to "loan to value" ratio to make up the difference between an appraisal price and contract price.

How can make sure you avoid your home sale falling through?

Buyers: Save up as much as you can, plus put in bids on homes where you have some wiggle room and/or the houses will definitely appraise higher (e.g. the ubiquitous "worst house in the best neighborhood"). Speak with your lender about worst case scenarios and about what your loan to value options are.

Sellers: Market your home as widely as possible so that you have the most qualified buyers to pick from. Ask the buyers to waive their appraisal contingency. Have your agent's trusted lender have a chat with the buyer's lender to ensure that everyone is aware of their options in case the appraisal falls through.

How much will the lender let me pay for this house?

Buyers : The lender will only lend you as much as an independent appraiser says the house is worth. 

Let's say you're looking to buy a house for $500,000 with 10% down ($50,000). If the house appraises for $480,000, you would need to bridge the gap between the appraised price ($480,000) and the contract price ($500,000). Since you're putting 10% down, the lender has promised to lend you 90% of the value of the home.

-90% of the $500,000 contract price is $450,000.

-90% of the appraised price of $480,000 is $432,000.

That means that the bank is no longer willing to lend you $450,000. They're willing to lend you $432,000. That means that you will have to make up the difference, somehow. 

-You can choose to put down additional money (should you have it) - in this example, that would be $18,000

-or you can ask your lender to adjust your "loan to value ratio" on your loan and put the same amount down. This means that your 10% down because a smaller percentage down, and your monthly payments will go up. They may not go up by much. Ask your lender to estimate how much. 

What is LTV (Loan to value)?  

LTV is how much the property is worth compared to how much equity you have in the home. LTV will determine how much the lender will allow you to lend on a particular home.

The lender wants to make sure that you have enough stake in the house so that you don't abandon the house. If you do abandon the home or stop paying on the loan, the lender wants to make sure they sell the house for enough money to get their investment back.

Be aware that higher LTV ratios mean more risk for the lender, which means you may be paying more for that mortgage (higher interest rates) or you may be paying PMI (private mortgage insurance).

    Mortgage Amount
Loan to Value Ratio (LTV) = -------------------------------------------
    Appraised value of house

Let's say you're looking to buy a house for $500,000 with 5% down ($25,000). If the house appraises for $480,000, the loan to value ratio will be 98% and too high a ratio for your lender. You pay choose to put down additional money (should you have it), in order to purchase the home.

98% = -------------------------------------------

In the example above, the buyer would likely need to come up with additional down payment funds. If their lender allows a 97% LTV (which would be $465,000 on this house), the additional funds would be $9,400. This can be a bad surprise at closing, if you don't have any additional funds to add and you may fall out of escrow. If you have released the appraisal contingency, you may also lose your earnest money deposit.

Ask your mortgage lender what their maximum LTV is.

This will avoid your disappointment when you find that perfect house that you may not be able to get a loan on.

These are some typical LTVs you may see, but your lender's allowable LTV may be lower:

Conventional Loan : Up to 97% LTV allowed
VA Loan : Up to 100% LTV allowed
FHA Loan : Up to 96.5% LTV allowed

Your mortgage lender is the best source of information for specifics on your loan, definitely make sure you speak to a lender early on, before you start looking. It will clarify what monthly payments you feel comfortable with, how much of a down payment (and closing costs) you should save up and how much of a loan your lender can extend to you. Happy shopping!