Why do banks appraise homes before lending money to a buyer?

Reader question: “I’ve read that banks typically do home appraisals when they are lending money to a buyer like me. Why do banks appraise homes before finalizing the loan and issuing funds? Is it just to find out how much the place is worth, or are there other reasons?”

The short answer: Banks appraise properties in order to determine the current market value. They do this to ensure that they are not “over investing” with the loan, by putting up more money than the home is worth. They also want to know the potential resale value in case they have to foreclosure on, repossess, and resell the property later on.

Here’s another way to look at it. Banks appraise home because they need to protect their investment. If you take out a loan for 20% of the purchase price, that means the lender is going to pay the remaining 80% of the purchase price. They are the majority shareholder, so to speak. So they want to make sure that, in the event of a default and foreclosure scenario, they don’t end up with a home that is worth less (in the current market) than the amount they have invested in it.

Appraisals are a prudent business practice and a requirement for nearly all mortgage loans these days.

Technically, Banks Don’t Appraise Homes – They Hire an Appraiser

Let’s get specific here. Banks don’t actually appraise homes before lending money to a buyer. They hire a licensed home appraiser to do the appraisal, once a purchase agreement has been signed by both the buyer and seller. The appraiser will then give a copy of the valuation report to the lender, so that they can make a financing and underwriting decision on both the property and loan.

If the property is valued at or above the mutually-agreed-upon purchase price, the deal will likely move forward. If the lender’s appraiser decides that the property is worth less than what you’ve agreed to pay for it, you have hit a snag. In the latter case, the loan might not move forward unless (A) the homeowner lowers the sale price, or (B) the buyer pays the difference. Scenario ‘A’ happens more often than scenario ‘B.’

Read: Dealing with low appraisals as a home buyer

As a home buyer, you would be wise to include a contingency within your purchase agreement that allows you to back out of the deal if the home appraises below the sale price. The contingency clause should also prevent you from losing your earnest money deposit in such a scenario. But that’s another subject entirely (follow the link to learn about it).

Not the Same as a Property Inspection

First-time home buyers often confuse the appraisal with the home inspection, and vice versa. Many people think they are one and the same, but they are not. The appraiser and the inspector have two different jobs to perform for two different “bosses.”

  • The appraiser is looking out for the lender’s interests by determining the market value of the property before the loan is finalized. The primary goal is to determine value.
  • The inspector is looking out for the buyer’s interests by evaluating the condition of the home prior to closing or settlement. The inspector is looking for possible defects, disrepair, and potentially hazardous conditions. The primary goal here is to determine condition.

So, why do banks appraise homes before lending money to a borrower? They do it to ensure neither the buyer nor the bank is paying more for the home than it’s truly worth. They do it to reduce their chances of ending up with an overpriced asset, in the case of foreclosure and repossession. In short, they do it to make a sound investment.