Question

Finance & Real Estate Open Ended Question

When underwriting a loan, a bank will require an independent appraisal (valuation) of the property for which the loan is intended. It will then provide a loan based on the lower of the Transaction Price and the Appraised Value. Explain why a bank does that in terms risk mitigation.

Answer 1

An appraised value is the value of a property based on a given point of time and transaction Price is the loan amount the bank intends to lend. A Loan-to-Value (LTV) ratio helps the lenders determine the level of risk they take on a mortgage loan. An LTV ratio is calculated by dividing the amount of loan by the appraised value of the property. The appraised value not correspond to its market price or selling price. When the money is lent near to the appraised value of the property, there is a greater chance of default of the loan. So banks always prefer to lend based on the lower of the Transaction Price and the Appraised Value so that the risk of default can be reduced. And at the time of default, the bank will liquidate the asset. Then, the amount of default can be easily realised from selling the asset if the loan amount is at lower of the Transaction Price and the Appraised Value.