With the market in its current state, and with the number of foreclosures on the market slowly starting to fall, one of the most important things for a buyer to consider, is to match the type of home they are pursuing with the type of loan that they are going for. Almost all mortgages will require an appraisal be done on the property prior to the lender being willing to make the loan with very few loan products being the exception. An FHA loan will require that the appraisal be done to higher standards than those of the appraisal required by a conventional loan and requires a minimum down payment, where as a conventional loan will have lower standards but will also require a higher down payment.
The appraisal that is required for a conventional loan will be based primarily on the actual value of the home. This can be accomplished by either the cost method, the income method, or the comparable sales method, but is almost always done with the latter. The comparable sales method of course is basically self explanatory. The Appraiser takes as resent sales as possible, with as similar features as possible, in as close proximity to the subject property as possible, and uses them to determine the value of the property being appraised.
An FHA appraisal on the other hand, will take into account all of those things of course, but will also make sure that the property meets the department of Housing and Urban Development’s “Minimum Standards of Living.” Some of the things the property can’t have are broken windows, or broken stairs (and if more than 3 steps there has to be a hand rail), it can’t have holes in the walls or ceilings, and if there is a spot for a built in appliance than that appliance must be present in the spot. There also must be a safely working electrical system, and an operable heating and cooling system. Generally summed up, the property can’t be in bad repair, and must be, in the terms of the appraiser, “livable”.
The big thing that a buyer needs to remember about the differences in these appraisals, and also the loans that go along with them, is that if a property is in bad shape, or sometimes just even a little TLC, it may not be feasible for a property to be able to pass an FHA appraisal. By pass, I mean that the appraisal must come back with either no noted repairs, or repairs that a seller is willing to do prior to closing. When a property is in foreclosure or possibly being sold at an attempt at short sale, especially when there is obvious work that needs to be done to a property, the bank or seller is often times not going to be willing to do the work. Without the seller doing the work, the property can’t be sold under that appraisal. Which means that a buyer who doesn’t qualify for a conventional loan, may not be able to buy a property that needs work.
What’s silly in this situation (but true even though it seems ridiculous), is that sometimes there will be only a minor amount of work that needs to be done, at a cost of a few hundred dollars, but because the seller is unwilling to do the work, and because the seller will not allow the buyer to do the work prior to close because of the liability to do so, the transaction can’t close, and the buyer can’t take advantage of the potential opportunity. In the event of the property being a foreclosure, a bitter pill to swallow, is that any and every buyer is only just a number to the asset manager 1000′s of miles away. They don’t care that a buyer may be a young family in need of a good start to their families financial life by purchasing a home with built in “sweat equity” or a middle aged person who has had some bad luck and could use a little help getting back on their feet. They only have their guidelines and policies to worry about, and don’t really care about anything else.
The last thing to remember about this topic is that there is a difference in loan terms attached to these appraisals as well. An FHA loan uses a lower minimum credit score, only requires a 3.5% down payment, gives the seller the ability to pay up to 6% of the purchase price for the buyer’s closing costs, allows higher debt to income ratios and lower mortgage insurance premiums which makes a home more affordable by lowering the monthly payment. It even allows the use of “gift funds” which can be given by friends or family members. A conventional loan, alternately, will have a 5% down payment minimum, has a higher mortgage insurance premium, and will only allow the seller to pay 3% of the purchase price in closing costs for the buyer.
So when you are trying to decide which homes you should see, and which homes will work for you, always keep in mind the amount of work that a property does or doesn’t need, and whether that property will pass an FHA appraisal. Always think about what funds you’ll have to use as a down payment and keep in mind what your credit score is as well, because once again, the FHA loan will allow a lower credit score for approval along with all of the other features.