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Buying a foreclosed home: The full breakdown

At a glance:

When a wave of foreclosures sweeps into the housing market, bad things happen.

Families must move, jobs get lost, property values fall, cities lose tax money, and communities risk fraying apart. Stable home ownership makes communities and families strong. When people lose homes, the lost ownership and tax revenue mean that the rest of the community is less invested in their neighborhood.

For those looking to buy, however, a wave of foreclosures can be just what they needed to enter into that home ownership.

It can bring home prices down to what some buyers can finally afford. Without this kind of price destruction, they may be stuck renting when they'd rather be owning.

Buyers of foreclosed homes may be professional investors, amateur investors, experienced homeowners, or new homeowners. They buy foreclosures for many different reasons.

If you are new to homebuying and are considering buying a foreclosed home, it is paramount that you know exactly what you are getting yourself into. It could be your best investment yet, or it could be your worst.

What is home foreclosure?

Foreclosure is a legal process by which a creditor — a bank, credit union, mortgage company, etc. — takes over a homeowner's property to satisfy a debt.

Foreclosure occurs when the owner of the property fails to make payments on the mortgage per the contract that exists between the owner and the creditor. As a result of the foreclosure, the owner loses the right to the property.

Foreclosure can also occur due to nonpayment of a second mortgage or even a home equity loan, as well as nonpayment of property taxes.

First-timers and foreclosures

It is advised by many that first-time homebuyers steer clear of buying foreclosures.

Those without experience may be shocked to find their newly bought property tangled in various legal issues (liens, judgments, etc.), in a state of disrepair, plagued by vandals, in a neighborhood of declining home values, and needing thousands of dollars in improvements that may not have been obvious earlier.

If you do decide to proceed as a first-timer, educate yourself on the risks first, and make sure your financial situation is solid.

Three stages

After the late payment stage, there are three stages of foreclosure:

  • The first stage is pre-foreclosure, when the owner receives a notice of default from the lender giving the owner a certain period of time to either sell the house or get payments up to date (mortgage payments and fees). Notices of default are public records and are therefore accessible directly or through various media, such as newspapers, and the local public records office. Pre-foreclosure typically sets in at 90 days.

  • The second stage is the public sale of the property, typically an auction, where bids on the home are accepted.

  • The third stage occurs only if stage two was not successful. In this stage, the lender takes title to the house and tries to sell it itself. Properties of this nature are called "real estate owned" properties, or REOs.

You can buy a home at any of these three stages. Each stage has its own issues and its own strategies for buyers to consider.

Advantages of buying a foreclosed home

Interested in buying a foreclosed home?

There are upsides and downsides. Let's look at some of the upsides, categorized here by each stage in the process. Compare them to the downsides before you make a decision.

Late payment stage

  • The owner of the home has an interest in keeping his or her credit in the best standing possible, as well as getting something of value for the home. The owner might therefore be motivated to sell quickly at a price that's good for both you and them.

  • The owner may be motivated to make needed repairs to the home.

  • The owner may offer concessions.

  • You as the buyer can use regular mortgage financing.

  • You are entitled to a full disclosure of the property's condition and any outstanding problems with it.

  • You can do an inspection of the property.

Pre-foreclosure stage

  • The owner has an interest in keeping his or her credit in the best standing possible, as well as getting something of value for the home. This means he or she may be willing to give you a good deal.

  • Because it is early in the process, you have additional time to do research on the home, the neighborhood, and anything related.

  • You still have time to do an inspection.

  • You have time to research the title.

Auction stage

  • Payment for the home must be in cash. This works to some buyers' advantage.

  • The home is typically sold for the outstanding mortgage balance. This might be lower than market value.

  • The closing date of the auction will usually be listed in the auction terms. This can weed out those who don't like being constrained by deadlines.

  • The auction may provide a due diligence packet of information on the condition of the property (you usually cannot inspect the property during this stage.)

REO stage

  • The lender (which is now the owner) may be willing to finance the home.

  • The owners or renters have vacated the premises by this time.

  • You are allowed to do an inspection of your own.

  • Property is usually listed on the MLS (Multiple Listing Service).

  • The lender is motivated to sell and will negotiate the price, the down payment, closing costs, etc.

  • By this time, the title will be cleared and there will be no liens, back taxes, or other surprises.

  • Regular mortgage financing is allowed.

Disadvantages of buying a foreclosed home

Buying a foreclosure is not a piece of cake, nor is it guaranteed to give you a great price. Read some of the downsides, categorized here by each stage in the process.

Late payment stage

  • The owner is still living in the home and may not move out on your schedule.

  • The owner may not be ready to offer the price you want. It is still early in the process.

Pre-foreclosure stage

  • By this stage, the owner may have begun neglecting maintenance and upkeep. Needed repairs may have started going undone.

  • You may need the lender's approval in order to buy for less than the mortgage and all other costs (this is called a short sale). The lender may not approve these.

  • The owner is likely still living in the property. Owners who are not likely to get a deal they like might take out their anger on the property, trashing it or looting valuable parts of it.

  • Timing: short sales can take many months to close.

  • There could be judgments on the property still.

Auction stage

  • You may have to compete with professional investors looking to buy the home and resell (flip) it right away. They have the wherewithal to bid up the price of the home. If you win it anyway, you may end up paying more than it is worth.

  • You will have to pay with either cash or a cashier's check.

  • The home will sell "as is." Don't ask for concessions, such as a newer furnace. You will probably not be allowed to do a home inspection, either.

  • If the owners or renters are still living there, you may need to resort to legal measures to get them out of there. That can be costly, frustrating, and time-consuming.

  • You won't have much time to research the home and learn its true worth.

  • Homes in foreclosure are often not in the best condition. If the previous owners couldn't pay their mortgage, then they probably neglected maintenance and upkeep. Be prepared to encounter filth, missing appliances, and equipment not working. Some owners decide to trash the place out of anger or steal valuables such as copper piping.

  • The lender won't likely provide a full disclosure of the property's condition.

  • The lender itself may try to outbid you.

REO stage

  • Working with the lender (typically a bank, credit union, or mortgage company) that now owns the property is famously difficult. Working with lenders can be very drawn out. You may wait weeks just to get a simple response to a question.

  • The lender wants to recoup its loan and recover its costs. Although it may be ready to cut you a deal, it will simultaneously do what it can to get the highest price.

  • Buyer's agent commissions for REOs tend to be reduced.

  • The lender won't likely provide a full disclosure of the property's condition.

  • With REOs, there is often extra paperwork.

  • The property will be sold "as is."

  • Even though the lender now owns the property, it will not do any upkeep or repairs on it.

If you still want to go through with buying a foreclosure after carefully considering the disadvantages, be sure you can address each of the disadvantages so that you are ready to proceed without surprises.

Tips for buying a foreclosed home

If you do your homework and stay realistic, you may find that a foreclosure home is your dream home. If you don't, you may find it your worst nightmare. Follow these tips to ensure a good experience.

Residence or investment?

Whether you intend to live in the home or sell it will make a difference.

If you intend to live there, you may have different preferences for the neighborhood and the home's features. You may also want to make repairs on a looser basis than you would if you were buying it for the purpose of selling it again soon.

Find a real estate broker experienced with foreclosures

Not only do they have expertise, but sometimes they know of homes that aren't yet listed.

They also keep up on local laws and other aspects of the market. Some brokers work directly with banks to sell REO homes.

Get a pre-approval letter before you start looking

Foreclosed homes can get snapped up fast. Unless you have cash instead, have the pre-approval letter from a lender first.

Keep a price range in mind

There's a chance you may get into a bidding war and spend more than you had hoped to. Set a maximum price and walk away if the bids exceed it.

See the home for yourself

Horror stories abound about people who bought a home from far away only to discover it was more of a dump than they'd been led to believe, or worse yet, it was a vacant lot.

Either see it for yourself (inspect it if possible) or send someone to see it for you. Also, it's a good idea to make sure that no one is still living in it. That can bring extra problems, such as the need to get an eviction notice.

Have plenty of cash on hand

Getting a home for a low price can make you forget why you're getting it for a low price.

Are extensive repairs needed? Make an estimate and set aside enough money for it. Then set aside a few thousand dollars extra. Also, remember that fixing up a home can sometimes increase its assessed value, which can raise your property taxes.

On top of this, there may be judgments and liens and the like attached to the home that need to be paid off.

Look at the neighborhood

If the home is in a distressed neighborhood, you might not get a good resale price.

If there is a lot of crime, you may have additional expenses such as vandalism to worry about. You may also get hit periodically by various assessments aimed at fixing bad infrastructure.

Then there are issues such as excessive noise, unruly neighbors, and such to keep in mind.

Look at the yard

Roots, branches, and vines can intrude into the foundation or through windows.

Pools of standing water can contribute to deterioration of basement walls. Make sure the yard is in good condition. The ground should be graded properly, brush should be kept at a safe distance, and concrete should be in good condition.

Learn how long the home has sat empty

The longer a home has sat empty, the more opportunity there is for decay.

Mold, bugs, sewer gases, and plumbing can get worse. Leaks in the foundation can also get worse. If the home wasn't winterized, there may be cracked pipes that will need fixing.

Get an inspection

If at all possible, invest in an inspection. It can save you thousands of dollars down the road.

At the very least, it can give you a heads up on where your money is going to go during the next few years.

In some cases, an inspection can give you time to make repairs in advance, saving you damages in the future.

Look into HUD homes

The Department of Housing and Urban Development (HUD) holds a fraction of the foreclosed homes. One advantage of HUD homes is that they stay maintained.

Be realistic, and do your research beforehand

Don't go into them expecting big profits quickly. Foreclosures can be a headache.

You can sink more money than you expected into them. They may not sell for what you expected. They may sit in your hands longer than you had hoped.

Summary of buying foreclosed homes

While the price may be enticing, the potential problems of a foreclosed home can quickly sour one's enthusiasm.

Foreclosure is best approached with a good understanding of why the home was foreclosed in the first place — this could shed some light on problems you may encounter later on in the process.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

Read more information and tips our Buying/Selling a home section

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