The dream of building your own home is a significant milestone in many people’s lives. Nationwide, realizing this dream can be challenging because of our current inflationary environment. In rural communities, these challenges can be even more pronounced, with appraisals often falling short of construction costs. In this blog post, we will explore how inflation affects property appraisals and why clients will likely need to come up with a 20% to 30% cash down payment to bridge the appraisal gap in rural areas.
Understanding Inflation and Its Impact on Construction Costs
Inflation is the gradual increase in the prices of goods and services over time. While it affects our daily lives, it also plays a significant role in the real estate and construction industries. As inflation rises, so do construction costs, including labor, materials, and land acquisition. This inflationary pressure can make building a new home more expensive than originally anticipated.
Inflation’s Influence on Property Appraisals
Property appraisals are crucial in determining the fair market value of a piece of land or a home. Appraisals are largely based on historical data and market trends. In an inflationary environment, where construction costs are rising steadily, these appraisals lag the true cost of building a new home and in turn the client receives a low appraised value for the home they are trying to build.
In rural communities, where real estate markets can be less dynamic than in urban areas, appraisals may lag behind actual construction costs even more. This gap can create a significant challenge for prospective homebuilders who rely on bank financing to fund their project.
The Need for Larger Cash Down Payments
Due to the discrepancies between appraised values and actual construction costs, clients interested in building their homes in rural areas will need more cash up front to make up the difference between appraised value and actual cost of building. Mortgage lenders typically require a down payment, which is a percentage of the home’s purchase price. In urban settings, a 10% to 20% down payment is commonly sufficient. However, in rural areas where low appraisals are more prevalent, clients may need to come up with 20% to 30% cash down payments to secure financing.
Here’s why a larger down payment becomes necessary:
- Risk Mitigation: Lenders want to mitigate their risk, and a larger down payment demonstrates the borrower’s commitment and financial stability. It also provides a cushion in case the property’s value decreases over time.
- Low Appraisal Coverage: When appraisals fall short of construction costs, a higher down payment helps cover the gap. Lenders are more likely to approve loans when borrowers have more “skin in the game.”
- Interest Rates: A larger down payment can often lead to more favorable interest rates, reducing the long-term cost of the mortgage.
- Avoiding Private Mortgage Insurance (PMI): With a 20% or higher down payment, borrowers can often avoid the additional expense of PMI, which is typically required for loans with lower down payments.
Yes, inflation impacts construction costs and there is a lag in property appraisals that necessitates larger cash down payments for those building a new home. However, the silver lining with inflation is that inflation has allowed properties in the United States to steadily appreciate over time. With a long-term perspective, should you build today, the actual cost of building should catch up with the appraised value over time as the cost of building continues to rise. There are certainly challenges to work through along the way, but with a long-term perspective, building still makes sense with a solid downpayment. Thanks for reading and we look forward to catching you on our next blog!