Why Do Mortgage Lenders Want an Appraisal Before You Buy or Refinance?

There's a simple reason why an appraisal is a crucial part of the process.

If you apply for a mortgage to buy a home or to refinance your current home loan, chances are high that your mortgage lender is going to require you to get an appraisal before approving you for the loan.

An appraisal is performed by a professional. The appraiser comes to your home, assesses its condition, and compares your property to recently sold ones in the area, making adjustments for the different features. The appraiser then provides an estimate of the home's fair market value.

Appraisals cost money, and they can sometimes derail your ability to get approved for a loan -- but they are an important part of the mortgage approval process. Here's why.

There's a simple reason mortgage lenders require an appraisal

Mortgage lenders require an appraisal before they will give you a loan because they need to make sure the home is valuable enough that it can guarantee the loan and the lender won't lose money if you don't pay the bills. Let's take a look at how that works.

Homes are collateral for mortgage loans

Your home acts as collateral when you take out a mortgage, and the lender has an ownership interest in the property. If you fail to pay the mortgage bills as promised, the lender has an asset to sell -- the home.

Because the home guarantees the loan, mortgage loans are secured loans -- which is why the rates are lower than with many other kinds of debt. The risk of loss is lower for lenders. But, to ensure that the house acts as sufficient collateral, lenders set a maximum loan-to-value ratio. That's the limit on the amount of money they are willing to loan you to a certain percentage of your home's value.

For example, if you want the best and most competitive rate, the loan would need to equal 80% or less than what the home is worth on the open market. So, for a $250,000 home, the lender would be willing to loan you up to $200,000.

An appraisal determines loan-to-value ratio

Many lenders will make loans with a loan-to-value ratio higher than 80%. In fact, some will allow you to borrow as much as 97% of the value of the home. If you opt for a loan-to-value ratio that's higher than 80%, though, you'll usually have to pay an extra fee for mortgage insurance. Mortgage insurance provides protection for the lender if they must foreclose.

To calculate the loan-to-value, though, lenders need to know what the actual market value of the home is. And that may be a smaller amount than you're willing to pay for the home. The appraiser conducts an assessment to paint the most accurate picture of the home's current worth so the lender can make sure they don't loan too much money for a home.

If the appraiser determines the home is worth less than you're paying for it, the lender may require you to put down more money or may not be willing to give you the loan. Otherwise, the lender is at risk of not being able to sell the house for a sufficient amount to get back all the money they loaned you for the home.

Unfortunately, this means if your appraisal comes in lower than expected, it could cause you problems in the home-buying process. If that happens, you could attempt to appeal your appraisal. But if that fails, you may need to bring more money to the table to either buy or refinance your current mortgage loan.

Appraisals are crucial for lender protection

Once you understand the role an appraiser plays, it's easy to see why lenders require appraisals. While this may be an added burden to overcome, it's also good for you to make sure a property is actually worth what you're paying for it before going through with the sale. Don't be disappointed to discover an appraisal is required when you're purchasing a home, as it's a crucial part of the mortgage approval process.