Mortgage Collateral refers to the asset that the borrower offers to the lender as security for the loan. Typically, this asset is the real estate property being financed. The value of this collateral is critical to private lenders and hard money lenders, as the real estate serves as a safeguard; it mitigates the financial risk by providing a tangible asset that can be sold to recover the loan amount in the event of default. For the borrower, the collateral can affect the terms of the loan, including the interest rate and loan amount.
In this Article
Why is Mortgage Collateral So Important?
The importance of accurately assessing the value of the mortgage collateral cannot be overstated. An overvalued property may lead lenders to approve loans larger than what the real estate is worth, posing a considerable risk if the borrower fails to meet repayment obligations. Conversely, an undervalued property might limit the borrower’s ability to secure the necessary funds.
Inadequate evaluation of collateral carries significant risks. If the property’s value is not properly ascertained, both parties stand to suffer. From the lender’s perspective, the inability to recover the loan amount from the sale of the collateral in case of default can lead to substantial financial losses. For the borrower, an inaccurate assessment could mean agreeing to less favorable loan terms or even facing foreclosure if the property’s market value declines and the borrower cannot meet the loan obligations.
How Do I Start Assessing Mortgage Collateral?
You should receive an appraisal from a licensed Appraiser. But be aware, you shouldn’t just rely on an appraisal, as it is very important you understand how appraisals work and compare them to your own findings.
Do Your Own Homework on Mortgage Collateral
Nothing beats doing your own homework yourself to start with and there are many online resources available to help you. You can often find this information for free by accessing the property appraiser database for the county and state in question.
Conduct Your Own Drive-by Inspection of the Mortgage Collateral
We recommend you only loan against properties within a reasonable driving distance. And drive by them FIRST and the comparables given by the appraiser in their appraisal report.
By conducting a thorough drive-by inspection, you can better protect yourself and ensure you are making a sound decision. This hands-on approach provides invaluable information that cannot be captured through checking online street views and property listings.
Drive-by the Subject Property
First, drive by the actual subject property and assess the property’s exterior condition. Look for signs of neglect, such as peeling paint, broken windows, or an overgrown yard, which may indicate underlying maintenance issues. Additionally, take note of any recent improvements or renovations, as these can enhance the property’s value. Pay attention to the roof, foundation and structural integrity.
Check Out the Neighborhood
The surrounding neighborhood is equally important. Examine the overall appeal and upkeep of nearby properties. A well-maintained neighborhood with tidy homes and manicured lawns typically signifies a stable and desirable area. Conversely, a neighborhood with numerous vacant or poorly maintained properties may suggest potential challenges in selling or renting the property.
Consider factors such as proximity to amenities, schools, and public transportation, which can influence property desirability and value. A property located near a popular local school can be much more desirable to familes with children, making the property much more saleable.
Review Comparables “Comps” to the Subject Property
Comparables, or “comps,” are one of the most important things during your inspection. The appraisal report will often list comparables based on other local properties to justify the subject property’s value. It is essential to drive by these comps and assess their condition and similarities to the subject property. Ensure they are genuinely comparable in terms of size, age, condition, and location. Discrepancies in the comparables can mean you are comparing apples to oranges and that is a risk.
Find Your Own Comparables in the Local Area
Don’t just rely on the appraiser’s report for comparables. Remember that an appraisal is subjective and the comps can be “cherry picked” to justify a higher or a lower price as outlined below.
You can look at online realtors’ websites and search for recently sold properties in your subject area. The question to ask yourself is has the appraiser considered these comps or can you find others?
If there are many properties shown for sale in your local subject area and they have been on the market for some time, this might indicate that properties are difficult to sell in that area. Until a property is sold, its value is not known, as final sale prices can change dramatically.
The Importance of a Licensed Appraisal
When evaluating mortgage collateral, obtaining an appraisal from a licensed appraiser is important. A licensed appraiser possesses the necessary qualifications, training, and state certification required to provide an accurate and unbiased assessment of a property’s value.
Relying on unlicensed or overly optimistic appraisers can pose significant risks. Unlicensed appraisers may lack the essential skills and ethical standards mandated by state regulations, leading to inaccurate or inflated property valuations. Such discrepancies can result in over-borrowing, where the loan exceeds the property’s actual worth. For lenders, an inaccurate appraisal can lead to substantial financial losses if the collateral does not cover the outstanding loan amount in case of default.
It is vital to ensure that the appraisal is certified to you and not just to the mortgage broker. Appraisals directed solely to brokers might not reflect the lender’s best interests and could be influenced by the broker’s desire for fast loan approvals. By obtaining a certified appraisal directly, you can be more certain that the evaluation is conducted impartially and adheres to professional standards.
Identifying Suspicious Appraisals
When evaluating mortgage collateral, it is important to scrutinize appraisal reports for any potential red flags that could indicate inaccuracies or deliberate manipulations. One of the most common issues to watch out for is the use of comparables that are geographically too distant from the subject property. Comparables, or ‘comps,’ are properties that have recently sold and are similar in size, condition, and location to the property being appraised. The proximity of comps is vital, because real estate markets can vary significantly even within short distances.
A suspicious appraisal might include comps that are located miles away from the subject property, in entirely different neighborhoods. This practice can distort the perceived value of the property, making it either undervalued or overvalued. To protect yourself, ensure that the comps used are within a reasonable distance, typically within a 1/4 mile in urban areas and up to several miles in rural areas.
Another red flag to be aware of is the concept of ‘cherry-picking’ comparables. Cherry-picking involves selectively using comps that support a predetermined valuation, rather than those that objectively reflect the market. For instance, an appraiser might choose higher-value properties to inflate the appraisal or lower-value properties to deflate it. This practice can severely impact the accuracy of the appraisal and, consequently, the loan decision.
To identify cherry-picking, examine the range of sales prices for the comps used. If the selected comps are at the extreme ends of the market, it could indicate manipulation. Additionally, consider the dates of the sales; comps should be recent, typically within the last six months, to accurately reflect current market conditions.
Communicating with the Appraiser
Contact the appraiser and tell them in writing that your loan is solely going to be based on the value of the real estate. Ask them to confirm in WRITING that they are aware that your loan is going to be based solely on the value of the property and, that in their opinion the property should sell in a forced sale for no less than 90% of the appraised value.
An Example Letter to the Appraiser
Dear [Name of the Appraiser],
I am writing to request your confirmation in writing to confirm your understanding that the value of the loan on the property located at: [Address], will be based solely on the value of the real estate.
In order to proceed with the loan approval, please provide your written assurance confirming your acknowledgment of the fact that the loan will be based entirely on the property’s appraised value. Furthermore, I would appreciate it if you could explicitly state in writing that, in your professional opinion, the property should sell at a minimum of 90% of the appraised value in the event of a forced sale.
Thank you for your assistance.
Sincerely,
[Your Name]
Choosing Your Own Appraiser
When evaluating mortgage collateral, one of the most critical steps is selecting a competent appraiser. Opting for your own appraiser can ensure a more accurate and unbiased assessment.
One of the immediate benefits of choosing your own appraiser is the assurance of impartiality. Brokers often hire appraisers who may have an inherent bias towards inflating property values to secure the loan approval. By selecting an independent appraiser, you significantly reduce the risk of overvaluation.
Finding a reliable appraiser involves thorough research and vetting. Start by seeking recommendations from trusted sources, such as real estate agents, fellow investors, or local real estate associations. Additionally, look for appraisers who hold certifications from recognized bodies, such as the Appraisal Institute, which indicate adherence to rigorous standards of practice.
When evaluating potential appraisers, consider their experience and specialization. An appraiser with a robust track record in residential properties may not be suitable for commercial or industrial properties. Match the appraiser’s expertise with the type of property you are dealing with.
If you are a regular investor with a mortgage broker, ask them to offer the loan to you first before having an appraisal done, as you will want to use your own appraiser and this will save the borrower paying for two appraisals.
Ultimately, it is better to turn down a loan than to lend too much against an overvalued property.
Conclusion
Without a good understanding on what your mortgage collateral is really worth, you are starting off your loan badly and things are unlikely to get any better if anything goes wrong.
Having a qualified and trustworthy property appraiser is crucial for both private and hard money lenders to ensure accurate and reliable property valuations. A competent appraiser not only helps in determining the true value of the property, but also provides assurance to lenders that their investments are based on sound and credible assessments.
In addition to a professional appraisal, it is vital to do your own homework and carefully read and check the appraisal. Find your own comps in the local area and drive in person to see the property for yourself. There’s nothing better than seeing the property and neighborhood yourself when making a decision to loan money.
Further Reading on Mortgage Collateral and Appraisals:
- Learn about appraisers from the Appraisal Institute.
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