How to Buy a Foreclosure
What’s Different When Buying a Foreclosure
If you’re in the market for a new home, foreclosed properties can be really appealing. It’s easy enough to find a listing in a neighborhood that would otherwise be out of your price range, but don’t be fooled by what looks like a great deal. Buying a foreclosure is something you should seriously evaluate prior to shopping or writing an offer. Check out “The Pros & Cons of Buying a Foreclosure” for more on the specifics.
If you’re up for the inherent risks, you’ll want to know how it differs from a normal real estate transaction, what options you have, and where to look.
In general, when purchasing a foreclosure expect a very impersonal experience. You’re most likely communicating with the lender or bank that owns the property and for them it’s just a business decision. If the numbers make sense they’ll make the deal, and if not then they won’t.
Understand that foreclosure is a process and there are multiple stages during which the homeowner can resolve the delinquency or a potential buyer can make a purchase. At certain stages you can get a better deal while taking on more risk, and in other stages you can absorb less risk but at the sacrifice of a bargain.
FACT: Foreclosures come in four primary flavors: Pre-foreclosures or short sale, auction, real estate owned (REO), and government owned.
As a group, these are considered “distressed properties.” They are distressed because of both the financial situation of the owner and also the physical condition of the property.
It’s critical to understand that distressed properties are often treated poorly by the previous owner; after all, someone was forced to leave their home. Chances are that if the owner wasn’t able to stay current on the bills, they weren’t able to stay current on maintenance or repairs either.
Often the owners will feel that the lender is acting in bad faith and will purposely cause damage to the home prior to their eviction. This damage can range from superficial, to the removal of hardware and appliances, and even the intentional damage of structural elements in the home.
That’s why it’s critical that you understand the risks you are taking and are willing to endure the as-is nature of the purchase and all of the baggage that entails.
Understand the Different Types of Foreclosure Properties
There are various stages of foreclosure and various types of entities that may be in possession of the property during the transaction. Each of these scenarios has its own caveats, so be conscious of the type of foreclosure you are dealing with and be diligent with any special considerations.
TIP: Don’t get caught up in the excitement of bidding. Consider the repairs and set a max price.
Pre-foreclosure or short sale
During pre-foreclosure the homeowner still has control of the property. The case is usually that the owner has stopped being able to make timely payments and likely negotiated with the lender to sell the house below market value, also commonly called a short sale. The owner vacates the property at the time of signing the short sale agreement.
You can make an offer to purchase the property, but the lender has to agree with the homeowner to accept less than the outstanding balance on the mortgage loan. This helps the seller avoid foreclosure, and the accompanying credit history blemish, while usually translating into a discount for the buyer below the home’s market value. It also helps the lender control costs by avoiding the foreclosure process.
Typically short-sale homes are in better condition than foreclosed properties because the parties have found a solution before a legal foreclosure proceeding begins. The home is still sold in as-is condition, but the buyer may have the right to inspect the property in advance without the right to ask the lender to fix any defects.
IMPORTANT: Keep in mind that when the property enters pre-foreclosure, which is somewhat of a grace period, the owner has several months to pay off the default amount.
Homes don’t always sell during the pre-foreclosure stage. Sometimes the property owner is not willing to remediate, and sometimes the lender is not willing to execute a short sale. In this case the home moves into foreclosure at which point it will be sold at auction.
Auctions are typically conducted by a neutral third party such as a trustee or sheriff. It’s important to note that during this phase the lender cannot take advantage of the property owner in any way, nor can the lender make a profit at the auction.
When the property is sold to the highest bidder, the liens are paid and any overage is given to the homeowner. Though typically, once the loans are paid, there is no money left.
Auctions are usually cash only, which tends to limit the field of bidders to investors and other lenders. Some states may allow a good-faith deposit with a short redemption period, but more commonly you need to hand over a cashiers check for the full amount immediately. It’s a good idea to register for a few as an observer to learn the lingo, rules, and nuances of the process.
Foreclosed homes are usually winterized to reduce the risk of damage to the property. The plumbing is drained, the hot water is turned off, and the windows may be boarded. In some instances, this as-is condition can limit how much you can inspect the property. When buying an auctioned home it’s common not to have the right to view or inspect the property.
IMPORTANT: Be sure to investigate the right of redemption laws in your state, which allow homeowners to reclaim their property within a certain period of time if they pay all past-due amounts and applicable fees. These vary state to state.
You will also want to have a clear understanding of any liens or encumbrances on the home. Make sure there are no surprise claims pending against the home that you may have to deal with after the auction.
Real Estate Owned (REO)
If the property fails to sell at auction it will move into the full possession of the lender and become real estate owned. REO is the most popular method of buying a foreclosure because it’s generally the easiest and safest way.
However, when you purchase a lender-owned property, it can offer the least value and most competition. Understand that the lender acquired the distressed property at the auction because no one bid higher than the default amount.
FACT: Now that the lender owns the property it can be sold for any price – even for a profit.
Generally lenders want to move this distressed asset off their books immediately and will price to reflect the market value of the property. For the buyer that means that there will likely be little room for negotiation.
The benefit here is that the lender is usually obligated to clear any additional liens on the property, including back-taxes, so it’s a much safer investment than an auction. Commonly the lender’s agent will also clear and clean the house for sale.
This tends to be a slower process and involves more paperwork than other types of foreclosure transactions.
Buying properties from the Federal Housing Administration (FHA), U.S. Department of Veterans Affairs (VA), Small Business Administration (SBA), Fannie Mae, Freddie Mac, Internal Revenue Service (IRS), or others can save you money. Some of these agencies may assist with financing, but the IRS requires full cash payment for the property.
IMPORTANT: “As is” condition means that you will accept the property in its present condition; what you see now, and discover later, is what you get.
Learn Where to Find Foreclosed Homes
The different types of distressed properties can be found on various sources. There are several consumer focused sites that can be found by conducting simple Google searches for “auction homes”or “foreclosure homes”.
The absolute best route to take is to work with an experienced real estate agent that specializes in foreclosure home sales. This is not just because they will have better access to available listings, but also because foreclosure transactions are very different from conventional real estate sales. You will want someone that can guide you through all of the twists and turns.
Specialized agents will have a network of contacts from traditional lending institutions, mortgage banks, other real estate agents, and residents living in areas where you hope to buy. Very often real estate agents work directly with banks to handle REO properties.
Foreclosure sale ads from the VA and the FHA are posted in newspapers on a regular schedule. Legal notices of default also run in newspapers.
You can also check online public records and the county courthouse. This is where all real estate transactions for a property in that county are recorded.
What You’ll Need to Do to Close
The most important thing to understand about closing on a foreclosure is that it’s a non-standard transaction and the lender will have their own processes and requirements. This is primarily a protective measure to shield the bank from any recourse by the buyer.
IMPORTANT: For REO’s the bank will want a pre-approval before considering any offers.
It’s recommended that you have a professional inspection performed prior to making an offer. The bank won’t allow for any contingencies in the offer, so be sure about your decision. Don’t skimp on the inspection either; it could end up costing you way more in the end if something gets missed.
This is where working with a specialized foreclosure agent can come in handy. Often times the agent can get their hands on a recent inspection report, saving you time and money before you decide to move forward.
TIP: You can finance your repair costs with an FHA 203(k) renovation loan.
It’s also prudent to run a comprehensive title search and report. Because of the uniqueness of the transaction, you’re more likely to discover additional liens on the property during closing.
Most lenders will not allow a transaction to close unless all of their requirements are met. The property will be transferred in as-is condition, so the buyer is taking on all of the burdens. There will be no seller disclosure requirements either because, after all, nobody from the bank has ever lived there.
Ultimately, buying a foreclosure is a complex process that can result in a true bargain when done right or a terrible decision when approached carelessly. Even professional investors can end up upside down on these transactions. If you’re ready to take the plunge, do your research, speak with a professional, set a budget, prepare for the worst, and take it one step at a time.
Resource Center & Glossary
- HUD: Foreclosure process inf
- HUD: Foreclosure listings
- FHA: 203(k) rehab and renovation loan information
Key terms – in plain Englis
As-is – Refers to a transaction where the property is transferred to the buyer in its current state, without any requirements for additional disclosures or any recourse available for the buyer against the seller
Auction – Occurring if a property goes into foreclosure. This is generally administered by a state agency and the bidders are usually required to pay cash at the time of purchase
Delinquency – When a homeowner fails to meet the terms of their mortgage for a prolonged period of time and after several notices
Distressed Property – Properties which are in distressed financial or physical state
Foreclosure – The process by which a lender can repossess a homeowner property in order to repay an outstanding debt
Real Estate Owned – Representing a foreclosed property that did no sell at auction and has returned to the possession of the lender
Short Sale – A real estate transaction that happens before foreclosure occurs, usually with the approval of the lender to liquidate the property for less than the outstanding loan balance