How Appraisals Affect Rent to Own
Many rent to own deals do not work because the buyer needs a mortgage to purchase the home, but does not qualify for one at the end of the lease. Often times, this has to do with the buyer’s credit score. But, sometimes, it’s out of the buyer’s control.
In many rent to own deals, the buyer and seller set the purchase price at the beginning of the lease term. They speculate the home's value at the end of the lease term. However, if they speculate the home's value at $110,000 at the end of the lease term, and it ends up worth $100,000, the home will not appraise.
When a home does not appraise at the sale value, the bank will not give the buyer a loan.
What is an Appraisal?
Bankers require buyers to appraise a property before they grant you a mortgage. The appraisal determines the value of the home you are purchasing. An appraiser determines the value of the home based on factors like location, size, view, the year it was built and comparables. Comparables, or “comps,” are properties similar to the one getting appraised. The appraiser will find properties within the area that have sold recently. The appraiser will narrow those properties down based on whether they have similar features and upgrades.
For example, it would make sense to compare a two-story home built in 2002 with a two-story home built in 2004. However, it would not make sense to compare the home built in 2004 with a one-story home built in 1984. Additionally, the appraiser would want to compare two homes with renovated kitchens as opposed to a home with a renovated kitchen and a home with an old kitchen. The same goes for pools, lakefront views, large backyards, garages, etc.
How Does an Appraisal Affect the Bank’s Decision on a Mortgage?
Banks appraise homes because it uses the home as collateral for the loan you use to pay for them. Collateral means something used to ensure buyers pay back the money they are lent.
For example, a buyer buys a $200,000 home with a 30-year mortgage. After 2 years, the buyer loses his or her job and stops making payments. The bank will not enter a situation in which it might lose the money it lent the buyer because he or she can no longer pay. The bank needs to protect its investment.
Instead, the buyer forecloses on the home and it becomes the bank’s property. The bank needs to be able to sell the home for at least what the buyer owes on it or the bank loses money.
For that reason, the bank would not want to give a loan to someone for more than the home he or she is purchasing is worth. The bank cannot recoup the costs if the buyer defaults on mortgage payments. It is not a safe investment.
The appraisal tells the bank what the house is worth. Therefore, the bank can loan the buyer a certain amount based on that appraisal. If the bank loans less than what the seller has priced the home, the buyer may not have the money to purchase the home.
While buyers do pay down payments that might cover the difference between the appraisal and the purchase price, many banks using conventional mortgages will not do deals with a loan-to-value ratio of less than 80 percent. Meaning, most bankers can give loans for 80 percent of what a home appraises for. The buyer covers the other 20 percent with the down payment.
So, for a $200,000 home, an 80 percent loan-to-value ratio would mean a $160,000 loan from the bank and a $40,000 down payment from the buyer.
How Appraisals Affect Rent to Own Deals
As mentioned before, when a home does not appraise at the sale value, the bank will not grant the buyer a loan. The buyer can increase the down payment so that the loan-to-value ratio is 80 percent. However, many rent to own buyers cannot come up with additional down payment money to reach that ratio.
Otherwise, the seller would need to lower the purchase price to the appraised value for the deal to go through. However, at this time the seller has the advantage. If the deal does not go through, he or she keeps the option fee and premium payments. The seller can turn around and sell the property or lease-option it to someone else while still following the law. Unless the seller is highly motivated to sell, there is no reason why he or she would lower the agreed upon price. The price was likely negotiated with all the other factors of the deal. Therefore, if the purchase price was high, rent payments may have been low or the lease term might have been longer. It isn’t in the seller’s best interest to lower the price. He or she will end up as the “losing” party in the deal.
While it can happen for any home purchase, in rent to own deals the sale price of the home is set far in advance. Therefore, accurate pricing is more difficult. It’s very difficult to predict how the market will change over time. Additionally, there are no comparables for future prices. Unless the buyer and seller work with an expert, the purchase price is unlikely to match the appraised value. Even when working with experts, the advanced price setting is an educated guess.
Buyers can avoid this issue by setting the price at whatever the house appraises for at the end of the lease term. However, this makes it more complicated for the buyer to plan how much he or she needs to save for a down payment and mortgage payments.
At the end of the lease term, the mortgage payments or down payment may be out of the buyer's price range. However, the buyer can research comparables throughout the lease to have a ballpark idea of what the purchase price will be.