Whenever you are looking to buy a new house and start negotiating on the pricing, you are likely to come across these two terms. Both are estimates for the price of a house. Appraisals are estimates by appraisers, and a fair market price is a more organic, consumer-based estimation.
In theory, these two prices should come out the same or about the same, but in practice, that is not always the case. This may be confusing. How can there be two different prices for the same house? Let’s take a close look at what is the difference between the appraised value and fair market value.
The appraised value or appraisal value is an independent appraiser’s estimation of a house’s value. Typically during the home buying process, there will be multiple appraisals done on the house. The seller will get his or her own, so they can determine a listing price to start at.
Then before closing on a house, your mortgage lender will likely require an additional third-party appraisal to ensure that their investment is safe. They do not want to provide a loan for a house that is extremely overpriced and potentially lose their investment.
The closing appraisal can be intimidating. At this stage of the process, you are pretty much set and determined to buy this house. If the appraisal comes in way over or way under the agreed-upon price, you may have to return to the negotiating table. However, most of the time those problems are avoided and evaluations are pretty similar across the board.
How is the appraised value calculated?
An appraiser considers multiple aspects when compiling his or her appraisal report. First, they need to complete a home inspection. This is a thorough inspection of the house inside and out. They look for things such as:
- Housing Dimensions
- Number and purpose of rooms (i.e. bedrooms, bathrooms, and kitchens)
- Structural integrity
- Included utilities, appliances, and amenities
- Condition of walls, stairs, floors, doors, ceilings,
- Health and safety regulations
- Code compliance
- Age and location
- Condition of gutters, roofing, siding, windows, porch
- Parking and garage
- Neighborhood details
Once they have the details that they need, they compare the home to other similar homes that recently sold. They try to find homes nearby with similar qualities, but if not then they slowly expand outward. Computer software makes this a reasonably quick process.
Then, the appraiser spends a few hours compiling all the data into a 10 or so page report. The report includes the appraisal value and the logic behind the appraiser’s estimation. Most valuations consider one or more of the following cost strategies: cost approach, income approach, and comparison.
Should I get an appraisal?
Getting an appraisal is a smart option whether you are on the buyer or seller side of the equation. As a seller, an appraisal helps you establish a listing price and ensures that you are not going to run into problems with prospective buyers in the future. You will know that your agreed-upon price will likely secure mortgage funding for your buyer. This makes the entire closing process quick.
As a buyer, as mentioned above, you will likely be required to get an appraisal before closing. If you are not required to or you decide to pay for the house in full or with alternative sourcing, an appraisal can still help protect your investment. You do not want to overpay for your dream house.
Fair market value
The fair market value of a house is a more objective estimation of a home’s value. Despite their objectivity, fair market valuations are not official appraisals. They are typically used as a starting point for the listing price if a seller decides not to get an actual appraisal to begin with.
Since the market value is flexible, a good way to think of the market value is to consider closing prices. What would you pay for this house?
Fair market value is determined by a few factors. It considers the property itself - size, location, and quality. It also considers pricing of similar homes as does an appraisal. Fair market value also takes into account the surrounding area and market trends. This makes fair market valuations more vulnerable to ups and downs in the real estate market and economy as a whole.
A fair market valuation is part of a comparative market analysis. Anyone with an understanding of the local market can provide an analysis. Real estate agents or brokers can help or point you in the right direction.
Which number is more important?
Both valuations are important during the home buying process. However, it would not be fair to compare the two as they each have a different purpose.
Fair market valuations are typically used so the seller knows where to start their listing price. A higher fair market value is good for the seller as it means that they will get more money from sale. A lower value means the house might sell below what the seller was originally hoping for.
An appraisal is a more comprehensive valuation. These two numbers can vary, but ideally they end up pretty similar. During the negotiating process, the market valuation will essentially be the agreed upon price. The appraisal will estimate to what degree that market value is correct.
If you are planning to get a mortgage as most people do, an appraisal is typically required by the lender before you can close. If you agree on a price of $200,000 but the appraisal comes in at $150,000 then something is clearly off. A lender will not provide funds with such a discrepancy and you will likely have to renegotiate a lower price.
Can a house be sold for more than the appraised value?
Usually, the listing price for a home will start off higher than appraised value or market value. Sellers are trying to find serious offers and make money in the process. They will usually come down a bit closer to the market value. But can a house be sold for more than the appraisal?
A low appraisal can result from a variety of issues. Negative market trends such as a buyers market can lower the appraisal. Poor and inexperienced evaluation strategies, inaccurate comparables, or incomplete data can lower the appraisal value as well.
If you require a mortgage then it will be difficult to agree on a rate that is significantly over the appraisal value. In the example above, a $50,000 difference will clearly raise some red flags for the lender. A smaller difference - something closer to $5,000 or even $10,000 - might pass through.
Should you pay more than the appraisal value?
If you get an appraisal that is under the agreed-upon price, meaning you will pay more than that house is worth, should you still pay? There are a few things to consider here. First, if the appraisal was requested by your lender, you may not have an option. If the difference is too big you might have to renegotiate to find terms the lender will agree with or find a new lender.
But if the lender is okay with the difference - let’s imagine there is a $5,000 difference - should you still pay? That answer depends on how much you want the house, which direction the local market is trending, or what the seller is willing to do to make up the difference.
One thing you should do if the appraisal is under the agreed-upon price, especially by a large amount, is to find out why. Is there a serious problem that you were unaware of? Or a major change in the market? This can help influence your decision as well.
Should you pay under appraisal value?
If the appraisal comes in below the agreed-upon price and the seller is committed to selling, you just found a good deal! However, the seller may decide to back out and negotiate for a higher price. To avoid this, as the buyer you can increase the price to make up for the difference. So, if the appraisal is $10,000 below the agreed-upon price, you can increase the price up to $10,000 to make the seller happy and keep the agreement alive.
If you feel that the appraisal was off, you can appeal or get a different appraisal. If the new appraisal is on target, you will be set. But if not, you will have to go back to the drawing board.
Knowing the difference between the appraised value and fair market value will help you seamlessly navigate the home buying or selling process. You can avoid any complications during the closing process by taking a careful look at both valuations. This means you will be asking the right questions and getting the right data from the beginning. All this combines to protect your investment and give you the most bang for your buck!