“Foreclosure” can be an ominous word in real estate, and the process can feel a little murky, since it varies from state to state. Savvy real estate investors should understand foreclosures in case they face foreclosure themselves or are interested in the investment opportunity foreclosed properties offer.
This guide will explain what is a foreclosure, steps you can take to prevent a foreclosure, and how foreclosed properties can be part of your real estate investing strategy.
What is a Foreclosure?
Foreclosure is a legal process where a lender takes ownership of a property from the borrower after the borrower fails to make multiple loan payments.
In a mortgage loan, borrowers agree to make monthly payments to pay off the property’s principal, interest, and taxes. When borrowers miss multiple payments, the lender will begin the foreclosure process to take back the property, since it’s legally theirs. Typically, lenders will repossess the property and then sell it to recoup what is owed on the mortgage.
Reasons for Foreclosure
There are multiple reasons why a borrower may get caught in a foreclosure, including:
- Increasing debt outside the mortgage
- A lost job, being laid off, or quitting a job
- Medical disability that forces the homeowner to stop working
- Job transfer to another region/state
- Excessive repair/renovation issues becoming too costly
- Divorce or family disruption surrounding homeowner(s)
- Other life disruptions that impact a borrower’s finances
Process of Foreclosure
The foreclosure process varies slightly from state to state, but here are the main stages of foreclosure that apply to most cases:
1. Missed payment
Foreclosure starts when borrowers begin missing payments. Most lenders have a grace period for borrowers to make a payment without penalty. After this grace period, the payment will be considered late, and the lender will send the borrower notice that they’ve missed a payment on the loan and may be at risk of late fees and even foreclosure.
2. Notice of default
After three to six months of missed payments, the lender will issue a notice of default with the local recorder’s office and send a copy to the borrower. The notice states how much the borrower owes on the loan and that they have 30 days to pay the money owed in order to get back into good standing.
3. Notice of sale
If borrowers fail to pay the missing payments within the allotted time, the lender will file a notice of sale with the local recorder’s office. The notice of sale states the date the home is officially up for sale and the minimum bid the lender will accept. Depending on state laws, the lender must also publicly advertise the property and sale date.
Before the property is sold, borrowers may also have the opportunity to exercise the right of redemption and pay the amount due to reclaim the home, depending on state laws.
4. Property sale
On the sale date, the property is considered up for auction and will go to the highest bidder that meets the lender’s requirements. Once the sale is complete, the deed is given to the new buyer, who then has possession of the property.
Borrowers have a few days to pack and move out of the property to a new residence after the sale. If borrowers do not voluntarily move out, law enforcement will be called to remove any people and belongings from the property.
Types of Foreclosure
The type of foreclosure depends on the state you live in and your mortgage loan terms.
In a judicial foreclosure, a lender files a lawsuit and the borrower is notified. The borrower then has a set amount of time to make up the missed payments; otherwise, the foreclosure process will continue.
Power of sale (nonjudicial)
Power of sale foreclosure is also known as a nonjudicial foreclosure. This type of foreclosure happens if the mortgage has a power of sale clause in the contract. When borrowers fall behind on payments, the clause allows the lender to auction off the property without involving a court.
Only a few states allow strict foreclosures. In a strict foreclosure, the lender files a lawsuit against the borrower, and if the borrower doesn’t make up the payments within the court-ordered amount of time, the lender can take possession of the home.
What Happens When Your Property Is Foreclosed
Foreclosure is a difficult process that no homeowner wants to go through. In addition to losing your home, there are other ramifications borrowers face, such as:
- Credit damage: Foreclosure can be damaging to your credit score, since a foreclosure stays on your credit report for seven years.
- Property and equity loss: Losing your home is both financially and emotionally devastating. You’ll also lose any money or equity improvements you put into the home.
- Remaining debt: Depending on your state’s laws, you may owe money if your home sells for less than you owe.
Preventing a Foreclosure
Foreclosure can be an overwhelming and scary situation. If you’re behind on your payments, there are a few steps you can take to work with your lender and avoid foreclosure.
Apply to refinance
Borrowers worried about missing payments should look into refinancing the loan into more affordable payments to prevent defaulting on the mortgage. Lenders usually only allow refinancing if the borrower hasn’t missed a payment, so this is a great preventative option. Contact your lender to refinance and understand your options.
Ask for a repayment plan
Contact your lender as soon as you know you will miss a mortgage payment to see if you can set up a repayment plan. These plans usually allow borrowers to defer payment for a month or two or make lower, but more frequent, payments.
Apply for forbearance
Forbearance allows borrowers to pause on their mortgage payments for a short amount of time to rebuild savings or increase income. Forbearance is typically granted when borrowers are navigating a short-term crisis, such as a job loss or other financial setback.
Give lender the property deed
If you know you won’t be able to catch up on your mortgage payments, you can sign a deed in lieu of foreclosure to voluntarily give the lender the deed to your home. By giving the lender the property deed, you’ll minimize the consequences that happen with a formal foreclosure. Providing the deed in lieu of foreclosure will still negatively impact your credit score, but not as much.
Apply for a short sale
A short sale is when the property is listed for an amount less than what the borrower owes on the mortgage. The lender must approve a short sale, and the home must be worth less than what the borrower owes on the loan. All sale proceeds go to the lender as well. This option helps borrowers avoid credit score damage that they’d receive through foreclosure.
Foreclosures as a Real Estate Investing Strategy
Many real estate investors like to target foreclosed properties as investments, since foreclosed homes can often be acquired for below market value. This makes it easier for investors to renovate and then rent or resell the property to make a profit.
However, there are some risks to buying foreclosed properties. The condition of the property is unknown, and there may be outstanding liens on the property investors have to deal with. Additionally, lenders don’t offer conventional loans to buy a foreclosed property, which means investors will need to come up with the entire amount to purchase the home.
Ultimately, there are pros and cons to buying a foreclosed property, and investors should take these things into consideration when looking into foreclosure listings.
Foreclosure is a stressful process and something no property owner wants to go through. Fortunately, there are steps you can take to work with your lender and avoid foreclosure. If you’re having financial difficulties, reach out to your lender early on to see what options you have to refinance or create a repayment plan.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.