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What Makes Buying a Foreclosed Property Risky?

By:
Sophia Merton
Updated
April 26, 2022

In the first quarter of 2022, there were more than 50,000 properties in the United States that started the foreclosure process. This represents a 67% increase from the last quarter of 2021 and a 188% increase from the previous year. With the increasing availability of foreclosures tempting real estate investors across the nation, it’s probably a good time to talk about what makes buying a foreclosed property risky.

While there can be benefits to purchasing foreclosures for seasoned investors, it’s important to understand that there are a lot of potential hidden costs to going this route.

Depending on whether you buy a home in pre-foreclosure, at auction, or as an REO property, the benefits and risks are a bit different. Regardless, it’s important to know that it’s not as straightforward as buying a turn-key house through the MLS.

This means that you’ll have to tune up the dial on your due diligence if you want to avoid making costly mistakes when buying a foreclosure. Let’s take a look at everything you need to know to make sure you're making the right investment decision.

What Is Foreclosure?

foreclosed home

When a homeowner repeatedly fails to pay their mortgage payments, the foreclosure process begins.

When you buy a property with a mortgage, your home is considered collateral for the mortgage loan. If a homeowner stops making mortgage payments, the lender can take control of the property through the lien that is a part of the mortgage contract.

When a lender seizes a property, they typically put it up for sale. If you see a home for sale that’s listed as a foreclosure, it means that the lender owns and is selling the property.

How Does Foreclosure Work?

The process through which a lender takes a home into their possession is known as foreclosure. There are a number of stages in the foreclosure process that are worth knowing for any property owner or real estate investor.

Payment Default

When a homeowner misses at least one payment on their mortgage, payment default has occurred. The entire mortgage can default if the homeowner misses several months of payments. Typically, this will begin the preforeclosure stage of the process.

Notice of Default

After ninety days of missed payments, homeowners will usually receive a notice of default from the lender. In many cases, the homeowner has the opportunity to work out a new payment plan with the lender in order to maintain possession of the property before the lender seizes the house.

Notice of Trustee’s Sale

If the lender gets to the point where they will be soon putting the home up for sale, they will need to record it with the county as well as publicize it in the local paper. You can use these resources to find foreclosures, but you might find that searching online is easier.

Trustee’s Sale

At this point, the lender will try and sell the home at a public auction.

Real Estate Owned

If the property failed to sell at auction, the property then becomes real estate owned. This means that the lender will take ownership and try to sell it on the market.

Why Are Foreclosures Typically Less Expensive Than Other Homes?

foreclosed property risky investment needs repairs

While foreclosed property can seem like a bargain, there are often hidden costs.

Foreclosed properties often have issues that need to be dealt with, including repairs, back taxes, liens, and more. This means that the invitingly low sticker price might not really be the full story when it comes to how much you will need to invest in the property.

That being said, it is definitely possible to get a bargain when it comes to foreclosed properties. Banks are just trying to recoup the outstanding balance of the loan since they aren’t allowed to keep any profit off of the property even if they did make one. Unless another creditor has a claim, the lender is required to pass any profit over to the original homeowner.

This is one of the main reasons that these houses can sell for such a low price. The lender simply isn’t motivated to make any more money than the outstanding loan balance.

If you see a foreclosed home that looks like too good of a bargain to pass up, it’s possible that is the case. However, others might notice too and the ending bid at an auction might be more than you are willing to invest. On top of that, you have to consider how many hidden costs might be attached to the property before you make your final decision.

What Makes Buying a Foreclosed Property Risky?

With housing prices as high as there are, it’s reasonable to try and find a deal for your next investment property. While foreclosures can have a less expensive sticker price, there are a number of risks involved that you’ll want to understand before considering buying a foreclosure.

The Property Might Be Occupied

Are you trying to buy a foreclosure at auction? Careful– there might be people already living there.

Whether it be the previous owner, their friends and relatives, renters, or squatters, you could automatically find yourself in the business of evicting people. This can be stressful, costly, and, to be frank, a nightmare. Depending on the state and municipal laws where your property is, you might find that getting rid of the people occupying the property is a steep uphill battle.

You’re Buying the Home “As Is”

inside of foreclosed house

Buying a foreclosed typically means you're buying it "as-is."

At public foreclosure auctions, the deal is that the highest bidder walks away with the property in “as is” condition. This means that the new owner now has possession of the title as well as all of the unpaid taxes, liens, and encumbrances that might be attached to it.

It Might Need a Lot of Work

If you’re buying a home as-is, that means that you're getting the property warts and all. While some foreclosures might be in practically move-in ready condition, others might have the symptoms of some seriously deferred maintenance.

It’s worth noting that the onus is on the buyer of a foreclosure to do their due diligence and the bank isn’t obligated to disclose red flags. Basically, the property that you thought was such a good deal can end up being incredibly costly in the form of necessary repairs and maintenance.

There Might Not Be an Inspection

When you choose to buy a property at a foreclosure auction, there won’t be any opportunity for you to have the home inspected by a professional. On top of that, you likely won’t even get the chance to step inside the house before it becomes yours.

Without an inspection, you might not be able to know about repairs that must be made until after you’ve become the legal owner. The property might have been looted or vandalized, the pipes could have frozen and burst, it could be missing light fixtures and appliances, and it could be infested with pests.

If you’re interested in buying foreclosed property but don’t want to take on the risk of doing so sight-unseen without an inspection, the better option is to purchase real estate-owned or bank-owned properties. Outstanding issues are typically addressed by banks once they take ownership of the property. When you go this route, you will have the opportunity to make an offer contingent on a home inspection.

You Might Not Actually Be Getting a Deal

It’s easy to get wide-eyed when you see how cheap foreclosures can be, but it’s important to remember that there are lots of different potential hidden costs. Once you deal with making repairs, paying to remove liens, and covering back taxes, you might wonder why you didn’t just buy that cute turnkey property just up the road.

There Can Be Delays

If you are on a tight schedule in terms of buying property, the foreclosure game might not be for you. The process is more complicated than if you were to just buy a traditional property.

For one, there are waiting periods included in the foreclosure process that differ between states.

Secondly, you’ll also have to wait for many layers of approvals that need to be made if you’re buying the property from a bank. The sale could even be stalled or completely stopped if there is a mistake in the document signing and filing process, allowing the previous owners to file for bankruptcy protection.

When you start searching for foreclosed properties, it’s important to understand that the legal issues that can arise could delay your closing date by weeks or even months.

Are There Any Benefits to Buying Foreclosed Property?

After that list of the risks of buying a foreclosed property, one might wonder, are there any benefits? Depending on the property and your investment goals, it is definitely possible that you can snag a great property that was foreclosed on. Let’s take a look at the potential upsides of investing in foreclosed homes.

Pre-Foreclosure

The pre-foreclosure part of the process can last for several months before a foreclosure is initiated by the lender. It also includes the period of time after a lawsuit has been filed or the initial notice has been sent up until the auction.

There are a few benefits to buying foreclosed property at this point in the process.

First of all, it gives you bargaining power. The homeowner might be motivated to sell the home fast if they’re underwater on the mortgage. If they are trying to sell it through a short sale, it means that the list price is less than the balance on their mortgage. In these instances, the owner and the lender might be motivated to make a concession when it comes to the price.

Another benefit of buying at this point is that the seller is required to give a complete history of the property’s condition. You have the opportunity to inspect the property and do normal title searches, which you won’t be able to do if you try to buy it at auction.

Lastly, you can purchase a property in pre-foreclosure using traditional financing methods. However, you also might be able to work out alternative mortgage financing with the sellers such as a mortgage assumption or a lease-purchasing agreement.

As far as downsides go at this stage in the game, the property might not be as much of a bargain as you’d like, there might be deferred maintenance in the home, and the seller could choose to back out if they figure out how to improve their financial situation.

Auction

When a foreclosed house goes up for auction, the lender is trying to make back the money they are owed for the rest of the loan. The price at an auction can start at the outstanding balance of the mortgage and fees. Sometimes they even try to encourage bidding by listing it lower than the amount they are owed.

At this point, you might be able to buy a property for a lot less than its market value. It’s also one of the quickest ways to buy a house, as you don’t have to spend weeks or months in negotiations as you would if you bought it during pre-foreclosure.

There can also be less competition at auctions than on the traditional market. Auctions typically require that bids are cash, which limits how many people are financially capable of participating.

Of course, there are cons to buying at auction, too. You’ll have to buy the property in cash and you might have to pay auction fees. You also won’t have access to any information about the property's history or condition and you likely won’t be able to do an inspection.

Additionally, any back taxes or liens become the buyer’s responsibility. It’s therefore essential to research the title before the auction if you’re interested in a particular property.

Lastly, you might have to deal with an occupied home when you go to check out your new place. This can be a difficult process that can drag on depending on the circumstances.

Post-Foreclosure

If a house doesn’t sell at auction, the property becomes real estate owned or bank-owned. This means it’s listed in the traditional market or potentially at an REO auction.

At this stage in the process, there are a number of benefits. Firstly, you can use a regular mortgage to purchase the property and have a normal closing period. Secondly, you might have the opportunity to negotiate down on the price, closing costs, down payment, escrow length, and more. There also might be special programs for federal mortgage defaults for owner-occupier purchasers if you plan on living in the property for a time.

Thirdly, the title will be clear at this point and you’ll be able to have a home inspection contingency as a part of your offer. Generally, the house will be vacant at this point in the process, meaning you likely won’t have to deal with evicting anyone.

How to Purchase a Foreclosed Home

If you understand the risks of buying a foreclosed property and are still interested in moving forward, you’ll want to learn about the steps in the process.

Know Your Options

You can buy a foreclosed property at an auction or when it is in a lender’s real estate-owned inventory. Sometimes, homeowners will sell the home through a short sale before the foreclosure has been completed.

In a short sale, your offer will need to be approved by the lender. This can be a slow process, so it’s likely not the best choice if you’re on a tight schedule.

If you buy a home at auction, the process is a lot faster than if you are negotiating with a seller or the bank. As mentioned above, auctions are typically cash only and frequently don’t allow you the time to have an inspection or even go inside the property before purchasing it. You’ll be buying the house as-is, and you don’t have access to the property’s condition or history.

The third option is buying a foreclosed property from the lender if it didn’t sell at auction. These are known as REO properties. Before the house is listed, the lender usually evicts the current homeowner and clears the title. These homes are still typically sold as is, but you will have the chance to have an inspection and view the property yourself before closing.

Consider Hiring an Agent

real estate agent foreclosed property

If you're interested in buying REO property, it's a good idea to work with an agent that has experience with the process.

If you’re specifically interested in foreclosed properties, particularly at the REO stage, a real estate agent can help you navigate the process. That being said, not all realtors will have experience assisting in the purchase of REO properties. Lenders will usually hand their properties off to an REO agent, and it’s best to find an agent of your own that has a history of working with these specialized agents.

Look For Foreclosed Homes

It’s finally time to start searching for a foreclosed property. Your real estate agent should be able to help you in your search, but many investors want to look for homes on their own time as well. There are a number of different websites you can use to search for foreclosures in your desired area, including:

  • HomePath.com (Owned by the Federal National Mortgage Association a.k.a. Fannie Mae)
  • HomeSteps.com (Owned by Federal Home Loan Mortgage Corporation a.k.a. Freddie Mac)
  • The Department of the Treasury site for homes seized by the IRS
  • The U.S. Department of Housing and Urban Development site for foreclosed homes

You can also check out the listings available on the websites for major national lenders, such as CitiBank, Bank of America, and Wells Fargo.

If you are specifically looking for pre-foreclosures, you can search on real estate sites like Zillow and use their search filters to look only at pre-foreclosures. Auctions often happen on the steps of the city courthouse and are managed by the law-enforcement authorities in the area. You can search for “sheriff sale auctions” and the name of your city to find local auctions or you can look in your local newspaper. There are also a number of sites, such as RealtyTrac, that list REO homes.

Get Preapproved For a Loan

You might be able to get a mortgage for a foreclosed property unless you are buying it at an auction. If you are financing the purchase with a loan, you’ll want to get preapproved ahead of time.

Are you wondering what you need in order to qualify for a mortgage? Check out this article.

Make an Offer

If you are working with a real estate agent, they can help you come up with a competitive offer for the property you’re interested in. This step is only applicable in the pre-foreclosure and post-foreclosure parts of the process.

Get an Appraisal and Inspection

Both appraisals and inspections are essential when you are purchasing a foreclosure. However, you don’t always have the opportunity to perform these two crucial steps when buying a foreclosure. Unless you are particularly experienced in the world of home repair and foreclosed real estate, it is a risky endeavor to buy a property without an appraisal or an inspection.

The appraisal is a process where a professional comes out to determine the value of the property. This is required by lenders because they want to know that they are loaning you the same amount or less of what the property is worth, not more.

A home inspection is performed by a professional inspector who goes over the property and notes all of the things that need to be repaired or replaced. It’s a fairly safe bet that foreclosures are going to have more damage than other homes on the traditional market, so an inspection is an important part of your due diligence.

Perform a Title Search

When buying any foreclosed property, it’s a good idea to perform a title search. This can help you learn about any liens against the home, back taxes owed, or any other surprises you might want to avoid. You can either use public records to perform the search or hire a title search company.

Close on the Property

It’s finally time to purchase your new property. You will want to thoroughly read the inspection and appraisal results in order to determine whether or not the property is a good investment for you to add to your portfolio.

Of course, if you bought the house at auction, most of these steps won’t apply. But if you are buying a home in the pre-foreclosure or post-foreclosure stage, you will have a closing process that is fairly similar to the traditional closing process.

What Does the End of the Eviction Moratorium Mean For Foreclosures?

In August of 2021, the CDC’s eviction moratorium expired. This was a nationwide ban put forward as a part of Covid 19 relief efforts. Some property owners also had the right to a COVID hardship forbearance, meaning that they could temporarily pause or reduce their mortgage payments if they were in financial trouble.

As one might imagine, foreclosures have increased significantly in 2022. In fact, there was a seven-fold increase in foreclosure starts in January when compared to December. While many of the people that applied for mortgage forbearance in 2020 and 2021 might have been able to get back on their feet, people who are still in forbearance in 2022 might not be able to bounce back once their forbearance expires.

There are a lot of opinions out there about what will happen with the housing market after a few crazy years of low inventory, historically low-interest rates, and rising prices. According to some estimates, the number of foreclosures is expected to rise throughout 2022. That being said, there are a lot of moving parts in the real estate market, and it’s never possible to fully predict what will unfold before it happens.

Are You Thinking About Buying a Foreclosure as a Rental?

Have you been through all of the risks of buying a foreclosure and you’re still interested in pressing forward? Do you have your eye on a specific foreclosed property that you think will be perfect to use as a rental?

If that’s the case, you’ve come to the right place. We’ve created the ultimate rental property calculator to help you look at all of the most important numbers in one organized space. After all, regardless of how good of a deal you snagged at the foreclosure auction, it’s always essential to make sure that all of the numbers add up in your favor.

Written By:
Sophia Merton
Sophia received her BA from Vassar College and has always maintained a deep interest in the question of how best to live one’s life. She hopes to help others understand how they can apply Stoicism in their day-to-day lives in order to become the person they want to be, embrace the present moment, pursue their purposes, and rid themselves of unnecessary anxiety.
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