Many people find themselves wondering the same thing when looking to buy a home – what’s the difference between appraised value and actual purchase price, and how does this affect me?
Let’s start with the basics.
A home’s appraised value is the estimated value of a home as determined by a professional through an objective assessment. The purchase price is, as you may expect, the cost that you pay for a property. While you might think that value = price, these numbers do not always line up exactly.
In the case that you purchase a home for a lower price than it is appraised, you would then make money (equity) on your purchase, and maybe could absorb some of the closing costs. This is not always the case.
While in a perfect world you would be able to buy a home with instant equity, have all their closing costs included, and bring as little cash to close as possible, knowing whether a home’s appraised value will exceed its purchase price is difficult to predict. In many cases, the appraisal process may not even begin until after a contract is signed.
So, what happens if the appraised value of a home exceeds its purchase price? Are there options to use this equity to pay closing costs? Read on to learn about some possible solutions.
How Do Lenders Treat a Higher Appraised Value?
On a purchase, the lending world has a guideline addressing this scenario. Traditionally, lenders use the purchase price or appraised value, whichever is less. So, what happens to this extra value? Well, there are some benefits down the road such as…
- Get rid of PMI quicker
- Obtain a home equity line of credit
- Pad your financial statement
- Make a better profit when selling the house
All of these examples are great and come in handy. But, many buyers want to know how to use this new found equity at closing. The most popular requests are…
- Does the higher appraised value lower my PMI?
- Can I get that extra equity as cash at closing?
- Can I roll my closing costs in the loan using the higher appraisal value?
Does a Higher Appraised Value Lower PMI?
When it comes to calculating mortgage insurance or PMI, lenders use the “Purchase price or appraised value, whichever is less” guideline. Thus, using a purchase price of $200,000 and $210,000 appraised value, the PMI rate will be based on the lower purchase price. Although, loans which allow borrowers to get rid of PMI could benefit from removing PMI quicker than the normal removal date stated eventually on the amortization schedule. This involves a process down the road with the lender. The higher appraised value and hopefully further appreciation could provide the required 20% equity much faster.
Higher Appraised Value Strategies to Include Closing Costs
So, let’s set the stage for this scenario. First, the buyer and the buyer’s agent have negotiated the best price possible. The contract is signed by all parties. We are going to assume that there are little to no seller paid closing costs included in the contract price. Therefore the buyer needs to have the ability to pay the down payment and closing costs on closing day. Now the appraisal comes in higher than the purchase price. In this scenario, we assume the buyer has the funds for closing. Of course, if the buyer does not have sufficient funds for the agreed upon terms, the buyer and Realtor should have never proceeded with the contract.
Renegotiate the Purchase Price to Include Closing Costs
Although the buyers and sellers sign at an agreed-upon price, this price may be renegotiated. As we mentioned, the buyer has the funds to bring to closing. So option number one is just to keep the price the way it is and enjoy the instant equity. But, an option to consider is increasing the sales price to include all (or a portion of) the closing costs. Why do this? Actually, there are several reasons, including:
- Borrowing “cheap” money (which is to say that it can be borrowed at a very low interest rate)
- Minimal increase in monthly payment
- Keep funds for emergency fund, home improvements, invest, or pay off debt
For example, assume $6,000 in closing costs and pre-paids. Using the purchase price of $200,000 and the appraised value of $210,000, the price could be renegotiated to $206,000 with $6,000 in seller paid closing costs. Depending on the interest rate and possible PMI, it’s likely that the monthly payment would increase $25 – $40 per month. Ask your loan officer for the exact amount.
Using the reasons above, a buyer could keep $6,000 in their pocket for whatever reason and have only a minimal increase in payment. This strategy is not just for low-to-no down payment buyers, either. Even buyers with 20% down payment or more could benefit from this strategy.
Again, it is cheap money. Many financial advisers could come up with a lot of things to do with $6,000 instead of paying down a low interest rate mortgage.
USDA Loan Allows Using Higher Appraised Value
Now, we are at the big reveal. Yes, a USDA Rural Development loan is the only known home loan which allows buyers to increase the loan amount to cover closing costs. This USDA benefit does not require a purchase contract change. All that needs to happen is a discussion between the buyer and loan officer about how much the loan could increase. Additionally, the advantages and disadvantages are discussed.
Keep in mind, the loan amount may only increase to cover the closing costs. Additionally, this increase may only go up to the appraised value, but the USDA funding fee may still exceed the appraisal. Actually, if the loan amount covers all closing costs, the buyer may even receive their earnest money deposit back at closing! Resulting in a true no cash to close purchase! Just remember the buyer cannot receive cash back at closing other than the documented earnest money.
Other USDA Benefits
USDA is one of the best loans available, but too many who are eligible fail to take advantage of it. USDA loans offer a no money down purchase with a very low mortgage insurance, liberal credit guidelines, excellent fixed rates, allows the seller to pay up to 6% of the purchase price in closing costs for the buyer. Plus, the benefit mentioned above. USDA loans do have a couple extra qualifying guidelines which are household income limits and USDA property eligibility. Even though these limit some buyers and properties, the USDA income limits help most families qualify and a majority of the U.S. properties are eligible.