There is a classic definition of what an appraisal is, yet what is the lender take?

Classic Definition:

An appraisal is like the official verdict on how much something is worth.

Real Estate Lender Definition:

This is an evaluation to see if the amount the house could sell for after one year, if the borrower defaults on the loan.

Here's the deal:

When someone wants to buy a house using a loan, the bank or the lender wants to make sure that the house is worth the amount of money they're lending. They don't want to lend $400,000 for a house that's only worth $350,000. That wouldn't be smart, right?

So, they send out someone called an appraiser. This person is like the real estate detective. They check out the house, look at its size, condition, location, and compare it to other similar houses in the area. Then, they decide how much the house is really worth.

This appraisal helps the bank or lender decide how much money they're willing to lend you for that house. It's like giving them a report card on the house's value before they decide to give you the loan. If the house doesn't appraise for enough money, it can mess up the whole loan process. So, it's a pretty important step in buying a house with a loan.

But here is the kicker:

The appraisal is influenced by the size of the down payment.

Most people think that when their house is being sold, it is a direct reflection the value of the house. That is incorrect. It is the direct reflection of value that the bank feels that they can get for the house if the borrower defaults.

So if a borrower puts down a larger than expected down payment and this is compared to historical appreciation, the appraised amount is a consideration of whether the bank can get back it's money. They don't care about the borrower's money, only their own.

The larger the down payment, the lower the loan amount equalling a higher chance the home will appraise for the requested amount, often known as the list price.

Taking the market I am in, as homes trend with 1%-5% appreciation in leaner times and 3%-7% in better times. This allows homes with even smaller down payments to appraise for the list price. That is one of the main factors why the prices keep rising.

How?

Let's consider a 1% appreciation because we are in a leaner market right now. Taking a $500,000 home, this states that in one year, if the borrower defaults, this means that the home would sell for $505,000.

If the down payment is 3% or $15,000, with the the resulting loan of $485,000, the lender might consider that this is too much of a risk to take on during the current time. A $20,000 "profit" is not really a win for the bank because it really doesn't want the house, it wants the cash flow from the loan. There are also costs in reselling the house, often of more than $20,000.

If the down payment is 10% or $50,000, the lender is more apt to consider the loan of $450,000, because a sale in one year of a home @ $450,000 is an easier win for the lender if the price trend is $505,000. There is a gain of $55,000 to cover costs.

That is why, the appraisal is based on the borrower's down payment or "skin in the game". The more the borrower has to lose equals a higher chance the property appraises for the list price.

In better times, lower down payment amounts are acceptable because the appreciation rate is higher which equals more leeway to cover lender future costs if needed. It is a teeter-totter effect.

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Steve