When homeowners stop making mortgage payments, their lenders don’t take kindly to it. And that's how foreclosures come to be.
But what, exactly, is a foreclosure?
Foreclosure is the legal process by which a lender attempts to get a buyer to repay an outstanding mortgage balance after that borrower stops paying their monthly payments. A lender that hasn't gotten paid can force the sale of a delinquent owner's home to recoup its money.
Foreclosure can be a miserable process for homeowners. But as a buyer, it can present an opportunity to snag a home on the cheap.
How foreclosure works
The exact foreclosure process varies from state to state, but here are the basics.
First, a borrower falls behind on his or her mortgage payments. When that happens, a lender typically gives that borrower a chance to catch up in the form of a grace period. During that time, a lender might agree to a different payment setup to help the delinquent homeowner get back on track. This is in a lender's best interest because foreclosure is an expensive legal process that costs money.
If, after some time, the borrower still fails to make payments to his or her lender, he or she can be served a notice of default. Typically, this gives the borrower 90 days to make a payment or risk foreclosure. If that borrower doesn't come up with the money, the lender can move forward on selling the home so it can recoup its outstanding mortgage balance.
Buying a foreclosure
Those interested in buying foreclosures can do so at auction at a courthouse or online. Anyone interested in participating in a foreclosure auction must register in advance, but these buying opportunities are open to the public.
Foreclosures sold at auction generally have to be paid for in cash. Buyers don't always need to come up with the entire purchase price at the time of the auction, but this is a requirement in most states. When it’s not, a down payment is required initially with the remaining balance to follow thereafter. As such, buying a foreclosure at auction isn't an option for buyers needing to finance a home purchase with a mortgage.
A delinquent home that doesn't sell at auction becomes bank-owned. At that point, the process of buying a foreclosure is similar to the process of buying a regular home. A buyer can search for foreclosures independently or through a real estate agent and make an offer. Cash offers are more likely to be approved, but it's possible to finance a bank-owned property via a mortgage.
Pros and cons of buying foreclosures
Foreclosures offer buyers a chance to snag properties at a discount, which is why they're often a popular choice among real estate investors. But foreclosures also come with many risks -- namely, hidden property issues that buyers aren't made aware of until it's too late and they're already locked in.
Homeowners who fall behind on their mortgages tend to have trouble with upkeep. Buying a foreclosure often means purchasing a home that's deep in the throes of neglect.
Homeowners who can't keep up with their mortgage payments should exhaust all other options before resigning themselves to foreclosure. Foreclosures stay on borrowers' credit records for seven years and can cause otherwise decent credit scores to plummet overnight.
Borrowers who fall behind on their mortgage payments should contact their lenders and ask for relief, which could come in the form of:
- refinancing to a lower interest rate,
- forbearance (when a lender lets a borrower pause payments), or
- loan modification (when the lender alters terms of a mortgage so it's easier for the borrower to manage).
When these options fail, selling the home in question is often the next best bet. Borrowers who aren't underwater on their mortgages can pursue a traditional home sale, but those who owe more on their mortgages than their properties are worth must ask their lenders to approve a short sale.
If a lender refuses to agree to a short sale, foreclosure is generally the only option. However, deed in lieu of foreclosure is sometimes a better option for both owners and lenders. This means the borrower voluntary surrenders his or her home.
Homeowners should avoid foreclosure at all costs. And although it may be tempting to buy a foreclosure, these properties are often best reserved for seasoned real estate investors with knowledge of the process and easy access to cash.
It's certainly possible to buy a foreclosure as a new investor, but those who go this route should be wary of the risks involved.