When financing a home purchase, a lender must ensure that it does not finance more than the home's worth. Usually, lenders require you to contribute a minimum amount of money to the transaction, known as a down payment, to help safeguard against this risk. Lenders also order an appraisal evaluation to determine the property value, which they expect to match or exceed the asking price -- the sale price on the contract.
Asking Vs. Financed Price
A home seller asks for a specific amount when listing his home, and this asking price may differ from the sale price the seller and homebuyer negotiate in writing. A seller can negotiate a price below the asking price or may agree to pay above the seller's initial asking price. If the seller agrees to pay more than the seller's asking price, she may run into an appraisal problem. Your mortgage lender's appraiser may estimate a lower home value, which affects the finance price -- the amount the lender can loan.
The appraiser works for your lender and its function is to protect the lender's financial interests. An appraisal evaluation consists of a visual inspection of the house and a market analysis to ascertain the property's condition and its value. The appraiser points out any defects that affect the home's value, marketability or occupant health and safety. The appraiser also requests a copy of the sales contract and may consider the contract price when he arrives at an opinion of value. The appraiser is under no obligation to arrive at a specific value for the property.
Financing and Down Payment
The financed price, or the maximum amount the lender can loan relative to the home's value, is expressed in terms of a loan-to-value ratio. An 80 percent LTV is standard, fetching you the best loan terms and interest rate; however, lenders may allow a higher LTV under certain loan programs. You make up the difference between the LTV and 100 percent of the home's value. For example, an 80 percent LTV requires a 20 percent down payment and a 90 percent LTV requires 10 percent down. When the appraised value exceeds the contract asking price, you base the LTV, and subsequently the down payment, on the lesser of the contract asking price and the appraised value.
When Appraisals Fall Short
In the event the appraised value falls short of the contract asking price, your lender recalculates the LTV based on the lesser amount. As a result, the gap between the financed amount and the contract asking price widens. For example, a home appraises for $195,000 rather than the negotiated sales contract price of $200,000. As such, the lender calculates the 80 percent LTV based on $195,000, which results in a financed amount of $156,000, rather than $160,000 for a $200,000 value. The buyer can compensate for the $4,000 reduction in financed amount by increasing the down payment contribution or renegotiating a lower contract asking price.
Karina C. Hernandez is a real estate agent in San Diego. She has covered housing and personal finance topics for multiple internet channels over the past 10 years. Karina has a B.A. in English from UCLA and has written for eHow, sfGate, the nest, Quicken, TurboTax, RE/Max, Zacks and Opposing Views.