Lenders require appraisals to confirm that the home for which they're providing you a loan is in fact worth the amount you're paying.
Three approaches to value
There are three general groups of methodologies for determining value. These are usually referred to as the "three approaches to value" which are generally independent of each other:
- The cost approach
- The sales comparison approach and
- The income approach
The cost approach
The theory is that the value of a property can be estimated by summing the land value and the depreciated value of any improvements. In most instances when the cost approach is involved, the overall methodology is a hybrid of the cost and sales comparison approaches. For example, while the replacement cost to construct a building can be determined by adding the labor, material, and other costs, land values and depreciation must be derived from an analysis of comparable data. The cost approach is considered reliable when used on newer structures, but the method tends to become less reliable for older properties.
The sales comparison approach
The sales comparison approach is based primarily on the principle of substitution. This approach assumes an informed buyer will pay no more for a property than it would cost to purchase a comparable substitute property. The approach assumes that a typical buyer will compare asking prices and seek to purchase the property that meets his or her wants and needs for the lowest cost.
Since comparable sales are not usually identical to the subject property, adjustments may be made for date of sale, location, style, amenities, square footage, site size, etc. The main idea is to simulate the price that would have been paid if each comparable sale were identical to the subject property. If the adjustment to the comparable is superior to the subject, a downward adjustment is necessary. Likewise, if the adjustment to the comparable is inferior to the subject, an upward adjustment is necessary. From the analysis of the group of comparable sales, the appraiser selects an indicator of value that is representative of the subject property.
Income approach
The income capitalization approach is used to value commercial and investment properties. Because it is intended to directly reflect or model the expectations and behaviors of typical market participants, this approach is generally considered the most applicable valuation technique for income-producing properties, where sufficient market data exists to apply this method.
Appraisers are independent agents normally hired by the lender, however you may have a choice. The fees appraisers charge vary and are typically built into your loan costs. Your lender may also require a Location Survey that certifies the house is within the boundaries of the lot. The lender often selects the surveyor, but again, you may have a choice. The lender usually pays for the cost of an appraisal then it's factored into the buyer's closing cost.
