Buying a Foreclosed Home

Before the mortgage crisis of 2008-2009, buying a foreclosed home was a much more difficult proposition. Real estate bargain-hunters formerly had to follow auctions put on at courthouses or sift through reams of legal filings. But the wave of foreclosures brought on by the subprime meltdown has not only increased the number of available properties, it has made it easier to find and acquire them. In fact, the process is often similar to the search for any other sort of home. Foreclosed homes are available in virtually every real estate market across the country, providing opportunities for homeowners and investors alike.

One can find foreclosed properties in multiple-listing service (MLS) periodicals and websites, via online real estate searches, bank offices and sites and local newspapers. There are many websites that now specialize in finding homes and properties that are in foreclosure, like usa-foreclosure.com and Fannie Mae's HomePath.com. Some financial institutions, like Bank of America, also offer pages dedicated to helping you search for a foreclosed home. In local multiple-listing services, properties that are being foreclosed upon may not be highlighted per se; this may only be stated in the property description.

Lenders increasingly are selling their seized assets through real estate agents, so don't hesitate to ask a realtor for opportunities. Some real estate agents even specialize in foreclosure properties.

More specifically, locating a foreclosed home depends on where exactly it is in the foreclosure process:  Properties can still be owned by the original homeowner  (in the earlier stages, in case of pre-foreclosure and short sale properties), or by an entity such as a bank or the government (in the later ones). Here are five types of foreclosure, and approaches to buying.

1. Pre-Foreclosures
A property is in pre-foreclosure after the mortgage lender has notified the borrowers that they are in default, but before the property is offered for sale at auction. If a homeowner can sell the property during this time, he or she may be able to avoid foreclosure proceedings, and its negative effect on their credit history and future prospects (see Getting a Mortgage After Bankruptcy and Foreclosure). As such, some homeowners are willing to negotiate. Pre-foreclosures are typically listed in county and city courthouse buildings. In addition, many online resources, including www.foreclosure.com, list properties that are in the pre-foreclosure phase.

2. Short Sales
Short sales occur when the lender is willing to accept less than what is owed on a mortgage. Borrowers does not necessarily need to be in default of the mortgage payments for a lender to agree to a short sale; however, they typically need to prove some type of financial hardship, such as the loss of a job, which is likely to result in default. Often the residence in question is underwater, meaning it is worth less than the outstanding mortgage balance. In order to qualify as a short sale, the lender must agree to "sell the property short" by accepting less than is owed, and the home must be listed for sale. These properties are usually advertised as short sales "pending bank approval."

Purchasing a short sale property is in most regards the same as a traditional purchase, but the language in the contracts will differ, specifying that the terms are subject to the lender's approval. A bank may take several months to respond to a short sale offer, so the process can take considerably longer than a traditional purchase. Many real estate websites, including individual firms or listing services, offer the option to search by short sale.

3. Sheriff Sale Auctions
A sheriff sale auction occurs after the lender has notified the borrower of default and allowed a grace period for the borrower to catch up on mortgage payments. An auction is designed for the lender to quickly get repaid for the loan that is in default. These auctions often occur on a city's courthouse steps, managed by the local law-enforcement authorities. The property is auctioned to the highest bidder at a publicly announced place, date and time. These notices can be found in local newspapers and in many online locations by performing a search for "sheriff sale auctions."

4. Bank-Owned Properties
Properties that do not sell at auction revert back to the bank; that is, they become Real Estate Owned (REO) properties. They are often managed by a bank's REO department, which maintains a listing of the  bank-owned properties. Online sources such as www.realtytrac.com have extensive listings that can be searched by city, state or zip code.

5. Government Owned Properties
Some homes are purchased with loans guaranteed by the Federal Housing Administration (FHA) or the Department of Veterans Affairs (VA). When these properties go into foreclosure, they are repossessed by the government and sold by brokers working for the government. A government-registered broker must be contacted to purchase a government-owned property. Buyers can research such properties on www.hud.gov (click on "TOPIC AREAS" and select "Homes for Sale").

The biggest selling point of foreclosed homes is, of course, their marked-down price – often significantly lower from other similar properties in the same area (known as comparables, or comps, in broker-speak). Most foreclosures are sold at 5% below market value, at least, with even greater discounts in certain regions. Buyers may also take advantage of additional savings with perks like reduced down payments, lower interest rates or the elimination of appraisal fees and certain closing costs.

What makes them such a deal? If the residence is in the pre-foreclosure or short-sale stage, its owners are in a financial bind – they need money. And time is not on their side: They have to unload the property, and get what they can while they can, lest they lose it entirely. In short, these sellers aren't exactly negotiating from a position of strength. While it may seem cruel to take advantage of others' misfortune, buyers can benefit.

They can benefit even more if the property has in fact been seized. The sheriff's office isn't interested in hanging onto a house; banks don't want to be in the landlord business. Financial institutions typically want to rid themselves of foreclosed properties promptly (for a reasonable price, of course – they have to answer to investors and auditors that they made every attempt to recoup as much of the original loan amount as possible). Again, this benefits buyers. 

Finally, foreclosed homes are usually sold in "as-is" condition – if there's damage, repairs aren't part of the equation – and, as used-car and vintage furniture aficionados know, "as-is" translates into a discount. Of course, "as-is" can be a double-edged sword, as we'll discuss below.

Property Problems

While it carries a compensatory discount, "as is" condition can be pretty grim. If the home is still being occupied by the owners, it is often poorly maintained – after all, if the people can't make the mortgage payments, they are likely falling behind on paying for regular upkeep as well, not to mention major repairs. In addition, some folks who are facing or forced into foreclosure are embittered, and take out their frustrations on their home before the bank repossesses. This often involves removing appliances and fixtures, and sometimes even outright vandalism.

Hidden Costs

Along with unforeseen repair and renovation work, delinquencies such as back taxes and liens (which auction properties often have attached to them, either by the IRS or state or other creditors) can add further costs to an otherwise desirable house. Whatever is owed, the government must first be paid and settled before the buying process can go forward. This applies mainly to properties being auctioned off; a bank will always pay off any liens attached to the property before reselling it to another party.

Slow Process

The preceding complications often mean lots of paperwork. Typically, foreclosures will have a number of additional documents that have to be completed to prepare for the closing, which isn’t always so timely. If it's a short sale situation, the owner's lender has to approve the deal and that can take a while, as mentioned earlier.  Serious damage found in the house can result in a lower home appraisal, which may affect the buyer's ability to secure a loan. Some lenders won’t lend below a certain dollar amount because the profit potential on a lesser loan isn't worth the risk.

While you'd think a bank would be eager to unload a repossessed residence, response times between the bank and other involved parties can be sluggish with REO properties too.The amount of time that it takes to get a response on your bid can vary widely; if the bank that holds your property is swamped with foreclosures, then it can take a great deal longer for the bank to process your request. Banks with substantial backlogs have been known to take up to 90 days to respond to an offer. If you plan to finance the purchase, you'd be wise to spend the time obtaining preapproval for a mortgage.

Competition

As with any market, whenever there's a chance to acquire something at a discount from the going rate, demand will soar. So increased interest and competition – not just from potential occupants but from investors and flip professionals – are inevitable when dealing with worthwhile foreclosed properties. Very often, a foreclosed home can be priced attractively below the other homes in the surrounding area, but when word gets out, numerous offers can come in rapidly and a bidding war ensues. So what was once an under-priced home in a great neighborhood can rapidly become a costly property.

Prospective buyers of foreclosed homes may be wise to submit bids on several properties at once, because it is possible for competing buyers to secure a property with a higher bid or an all-cash offer. But don't get discouraged if someone else trumps your offer for a particular property; check back periodically to see if it reappears in the bank's inventory. Foreclosure deals tend to fall through quite often.

If buying from a bank, you'll need to sharpen your bargaining skills and start the process with a lowball offer on the property you want. Banks that have accumulated sizable inventories of foreclosed properties will be more inclined to negotiate on price; the longer that the bank has held the property, the greater the odds that it will seriously consider lower offers, especially on properties that have been held for longer periods of time. Therefore you should probably make your initial bid at a price that's at least 20% below the current market price, or perhaps even more if the property you're bidding on is located in an area with a high incidence of foreclosures.

If you can pay for the property and any necessary renovations in cash, you’re in an enviable position. That’s why some buyers decide to team up with outside investors who can help them out on the front end and share any profits when the home goes on the selling block once again. In fact, cash deals represent a sizable portion of REO sales.

You can use a mortgage to buy a REO property, though private lenders tend to be skittish about financing foreclosure deals. However, two financing options are available for those who qualify – 203(k) loans from the Federal Housing Administration (FHA), and the HomeSteps program through Freddie Mac, one of the government-sponsored enterprises that repurchases mortgages.

203(k) Loans

The FHA designed its 203(k) mortgages to help assuage the concerns of banks that would otherwise shy away from high-risk REO. purchases. By charging borrowers a mortgage-insurance premium, they’re able to guarantee loans made by private lenders who participate in the program.

For borrowers, one of the big advantages is the ability to finance the home purchase, plus any required repairs, in a single mortgage. The more basic version, a streamlined 203(k) loan, is meant for limited repairs that don’t require engineering or architectural plans. Individuals can borrow up to $35,000 above the home’s sale price to cover basic remedies such as new appliances, siding and windows.

With more extensive fixes, such as building an addition or taking care of structural damage, a traditional 203(k) loan is usually the best option. Unlike the streamlined variant, homeowners must take out at least $5,000; the maximum amount is based on FHA limits for each county. Additionally, you have to pay for an independent consultant to inspect the property and verify that the work meets program guidelines.

An additional drawback to these loans is the price. Besides paying mortgage insurance, borrowers typically pay interest rates that are a quarter of a percentage point higher than those on conventional loans. They may also have to fork over one or two points, which are upfront fees that are each worth 1% of the principal amount.

Figure 1. A comparison between traditional 203(k) loans and the streamlined version.

(Source: Bank of America website)

HomeSteps

Freddie Mac provides liquidity to the mortgage market by buying loans from banks, pooling them and selling them to investors as securities. With HomeSteps, the organization – through its private lending partners – offers special financing for those who want to buy only the foreclosed properties that it owns. HomeSteps is currently available only in the following states: Alabama, Florida, Georgia, Illinois, Kentucky, North Carolina, South Carolina, Tennessee, Texas and Virginia.

If you happen to live in one of these states, HomeSteps has some significant benefits. Chief among them is that you don’t have to buy mortgage insurance, which sets it apart from 203(k) loans. That alone can save buyers hundreds, even thousands, of dollars over the course of the mortgage. Further, a HomeSteps mortgage doesn’t require an appraisal at origination, which can be a major hurdle for those seeking a conventional loan.

Buyers can find a list of single-family, condo and multi-family properties on the HomeSteps website.

On the surface, foreclosed homes can seem awfully appealing. However, costs can be extremely unpredictable and underlying damages could make a property undesirable. The buying process is often sluggish, which might spur second thoughts in the minds of buyers, while heavy demand for enticing foreclosed properties might push some hopeful purchasers away.

With all this being said, foreclosed homes can wind up being incredible deals. Buyers have the unique opportunity to pay below-market value for homes which wouldn’t be available to them under normal circumstances. If there are savings on the acquisition side, it improves the likelihood of the buyer realizing  appreciation of his asset, and a gain on his investment if he sells, in the future.

If done responsibly, purchasing a foreclosed home can allow a buyer to reap a myriad of benefits for many years to come.