First, it is important to highlight that lenders almost always use the estimated property value provided in an appraisal report rather than a lower value. This is important because the lender uses this property value to determine your loan-to-value (LTV) ratio, which is your mortgage amount divided by the fair market value of the property being financed.
Lenders apply maximum LTV ratios depending on your mortgage program and other factors. If your property value is lower than expected that could push your LTV ratio above the maximum limit and create a serious challenge to get your mortgage approved. This is called the appraisal coming up short.
For example, if you are obtaining an $80,000 mortgage to buy a home that you think is worth $100,000, your LTV ratio is 80% ($80,000 / $100,000 = 80%). But if the lender uses a property value of $90,000 instead of $100,000, your LTV ratio is 89% ($80,000 / $90,000 = 89%).
If the lender’s maximum LTV ratio is 80%, you could be required to make a bigger down payment to qualify for the mortgage. Alternatively, the lender may charge you a higher mortgage rate and require you to pay private mortgage insurance (PMI), which is an extra monthly cost.
This example demonstrates the importance of your property value when you apply for a mortgage and highlights why it could be problematic if the lender uses a lower property value than the estimate provided by the appraisal report.
Review the Appraisal Report for a Mortgage
So under what circumstances would a mortgage lender use a lower property value? After all, the appraisal report is provided by a licensed appraiser and contains comprehensive information and analysis to support the property value it provides. There are two potential reasons for the lender to use a different value.
First, some lenders perform an in-house analysis of a property's value using numerous information resources and databases. This analysis may produce a different and lower estimated property value than the report provided by the appraiser. In this scenario, the lender may adopt the more conservative approach and use the lower property value because this tactic offers more protection for the lender.
The second reason why a lender may use a lower property value is if the property is located in a neighborhood designated as a "declining market" by Fannie Mae, an organization that helps determine mortgage lending guidelines among other roles. An area is classified as a declining market if overall property values are falling at a relatively high rate.
If a property falls within a declining market, the lender typically applies a 10% discount to the estimated property value provided by the appraisal report to determine your LTV ratio and in turn the mortgage amount you qualify for.
We should emphasize that the concept of declining market stems from the real estate crisis in 2008 and 2009, when property values in certain neighborhoods declined rapidly for an extended period of time. With the recovery of the real estate market over the past ten-plus years, the declining market criteria is almost never applied to determine your property value when you apply for a mortgage.
In fact, the housing market has improved so much that it is now possible for certain applicants to qualify for a mortgage without a formal appraisal report, depending on the property, loan amount and other factors. In these cases, lenders use an automated property valuation system which can save borrowers both money and time.
Appraisal Report Area Guidelines: https://www.fanniemae.com/content/guide/selling/b4/1.3/03.html