Buying foreclosure homes skyrocketed in popularity in the wake of the housing bubble and Great Recession in the late 2000s, as an enormous wave of foreclosures swept the market.
While there are far fewer foreclosures taking place today, buyers can still sometimes score a deal. But foreclosures come with their own unique risks and drawbacks as well.
Make sure you understand both how foreclosure sales work and their risks before signing on the dotted line.
Where to Buy Foreclosed Homes
Before you can understand the pros and cons, you first need to understand the various stages of the foreclosure cycle, because the buying process differs at each stage.
When mortgage borrowers first fall behind — or even before they default — they can contact their lender to discuss listing their home as a short sale. Alternatively, if they fall several months behind on payments, the lender initiates the foreclosure process.
Eventually the home goes to public auction, but most foreclosed homes don’t actually sell at auction, so the bank usually takes ownership. These bank-owned properties are called “REO” properties, an acronym for “real estate owned” by the bank. They then list it for sale with a real estate agent.
Short Sales
In a short sale, the homeowner contacts the lender and explains they can no longer afford the monthly payment. But they can’t sell the property to pay off the loan, because they’re upside-down on their mortgage.
After appraising the property, the lender may agree to a short sale: accepting a lower payoff than the loan balance. The homeowner lists the property for sale with a real estate agent, and hopes a buyer comes along with an offer the bank will accept. It represents one of the best ways to avoid foreclosure as a homeowner.
As a buyer, it’s hard to score a great deal on short sales. Lenders simply won’t accept less than market value in most cases. By all means, make offers on properties listed as short sales, but expect plenty of red tape and long delays by the lender.
Pre-Foreclosures
The best deals lie in pre-foreclosures. But they also come with plenty of challenges.
Foreclosures take a long time, and lenders typically can’t even start the process until the borrower has missed at least four months of mortgage payments. Even after the lender initiates the foreclosure process, it takes many more months of legal proceedings and advertising the auction.
In that months-long window between when the lender files to foreclose and the actual auction date, some homeowners wake up to the risk of losing their home and become more willing to sell it. Those with equity may take a low offer, as long as the buyer can settle quickly and certainly.
When I first graduated from college, I worked for a real estate investor who specialized in buying pre-foreclosures. He always made homeowners two offers: an outright purchase offer at a fair price, and an offer to stay in the home as a rental and buy it back for a surcharge.
The overwhelming majority of homeowners chose the latter option. Most ended up defaulting on the rent and losing their home to my boss, along with all their equity. For years, I pondered the ethics of it. I eventually decided that while my boss was unethical for other reasons, this wasn’t one of them, because he always offered transparent choices to adults of sound mind.
Unless you personally know someone in foreclosure looking to sell, you should probably avoid this strategy. Homeowners in foreclosure get hundreds of mailings from real estate investors, bankruptcy attorneys, and others. Unless you plan to buy as a real estate investor, leave this strategy to the pros.
Foreclosure Auction
After months of legal proceedings, properties go to foreclosure auction if the borrower hasn’t caught up on payments, declared bankruptcy, sold the property, or found some other way to stop the foreclosure.
You can show up to the auction and bid, after showing proof of funds. But you should understand the drawbacks first.
To begin with, foreclosed homes are auctioned off at the courthouse, not at the property. Buyers can’t actually enter the property to see it and inspect the condition, because at the time of auction, the homeowner still legally owns it. So unless you have personal knowledge of the property, you have to bid blind to the property’s condition.
If you do bid and win, you typically have 24 hours to come up with the remaining deposit — often 10% of the purchase price — and either 30, 45, or 60 days to settle on the property, depending on your state. You can also expect some additional legal headaches and red tape along the way. Financing properties bought at foreclosure auction gets tricky too, because the homeowner may make access to the property difficult for appraisals or home inspections.
Only bid at a foreclosure auction if you personally know the property and its condition.
REOs: Bank- or Government-Owned Properties
Most properties that go to foreclosure auction don’t actually sell there. Either no one bids, or no one bids enough.
In fact, at foreclosure auctions, most lenders refuse to accept anything less than the total amount owed. Since most borrowers in foreclosure don’t have much (if any) equity, that means lenders start the bidding above what any buyer would actually consider paying.
So most homes that go to foreclosure auction end up reverting back to the lender. Or, in many cases involving federally-backed mortgage loans, ownership reverts to the government. It takes several months after the auction for the lender or government to go through the process of taking legal ownership, then months more to evict the previous owners if they haven’t already moved out.
But neither the lender nor the government are in the business of owning single-family homes. They don’t want REO properties on their balance sheets; they want their money back. So they hire a local real estate agent and list the property for sale.
At this stage, anyone can see the properties listed on the multiple listing service (MLS) — and therefore on public websites like Zillow, Realtor.com, and others — and can make appointments to tour them. Don’t expect killer deals at this stage, because you’re bidding on a publicly-listed property just like any other.
Still, most foreclosed properties need some degree of work. Defaulting homeowners who feel pushed out of their homes don’t exactly leave them spick and span. Buyers can sometimes score a decent deal on an REO property, just like any other fixer-upper.
Benefits of Buying a Foreclosed Home
Foreclosures come with one glaring advantage: the possibility of buying below market value. By definition, foreclosures are distressed properties sold in as-is condition. That often translates to a bargain price.
Buyers can sometimes save money on foreclosures in other ways as well. For example, some home loan programs exist specifically to incentivize buying foreclosures, and can include lower down payments, lower interest rates, lower fees, or other perks. More on these loan programs shortly.
The pros to buying a foreclosure are intuitive enough, but the cons get more complicated.
Downsides of Buying a Foreclosed Home
You already understand that no matter what stage of the foreclosure process you buy at, you’re buying a property in as-is condition. Most foreclosed homes need some degree of updating or repairs, even if only cosmetic.
But complications only expand from there. Depending on the stage of foreclosure, you may or may not have access to the inside of the property. If you can’t access it, you have no notion of the property’s condition. It could be pristine — or it could have major structural flaws such as foundation problems or a sieve roof. For all you know, the property has been consumed by toxic mold and needs gutting.
Even if you can get into the property before bidding on it, you have no guarantees that the homeowner won’t vandalize it out of spite before leaving. At best, you only know the property’s past condition, not its condition at the time you’ll actually take possession. I’ve seen vandalism on the scale of tens of thousands of dollars, such as punching through every cabinet door, shredding hardwood floors, and pouring concrete down every drain.
Those risks aside, foreclosures typically come with time pressure. Assuming you can get in to see the property, you still might not have much time to bring in a professional home inspector or contractors for quotes. Most conventional mortgage lenders also struggle to close loans in less than three or four weeks.
You’ll likely need to pay any back taxes unpaid by the former owner as well. That includes both unpaid property taxes and any income tax liens against the property.
Then there’s the bureaucracy involved if you buy a short sale or REO property. Both the government and banks are notorious for their red tape, which will complicate and slow your deal further. Expect to fill out even more forms than usual, and wait around for these types of property owners to get back to you with their own mandatory forms and approvals.
Finally, expect some competition from professional real estate investors. While they probably won’t outbid you on price, many come in with enticing cash offers. They know the process better, and can settle faster and with more certainty.
Tools for Successfully Buying Foreclosures
You should definitely do your homework on how to buy foreclosed homes, and try out these extra tools and tips.
Several websites and online software tools can help you find foreclosures. For REO properties, check out Fannie Mae’s HomePath website. Some larger banks such as Bank of America also have dedicated REO websites.
For pre-foreclosures, expect to shell out some money for commercial services. Two of the better services on the market are Foreclosure.com and Propstream, although both are designed for professional real estate investors, not homebuyers.
You can also look into loan programs optimized for foreclosures. Fannie Mae’s HomePath ReadyBuyer program allows up to 3% in closing cost assistance when you buy a foreclosure owned by Fannie Mae, and they allow some borrowers to put down as little as $500 for their earnest money deposit. Freddie Mac offers a similar program called HomeSteps, which waives the private mortgage insurance requirement and doesn’t require borrowers to pay for appraisals.
Also explore the Federal Housing Administration’s 203(k) program, designed for fixer-uppers. You can borrow renovation costs as part of the loan, but beware that you’ll pay mortgage interest for the entire life of the loan.
Should You Buy a Foreclosed Home?
If you don’t mind fixer-uppers, consider looking at short sales and REO properties listed on the MLS. The process for buying them is similar to buying other publicly-listed properties, albeit with a few extra hoops to jump through to satisfy bureaucratic banks.
Most homebuyers should pass on pre-foreclosures or foreclosure auctions however. You can’t access the interior of the home without the homeowner’s permission, and even contacting these homeowners involves a massive effort on your part. If you send direct mail campaigns to homeowners in foreclosure, you can expect a response rate in the 1% to 3% range. And few of the people who respond to you will end up actually selling to you.
Word to the wise: leave them for professional real estate investors.
Final Word
In a seller’s housing market, it’s tempting to try and score a bargain home however you can. That goes doubly for first-time homebuyers.
Just make sure you understand exactly what you’re getting yourself into before bidding on a foreclosure property. Complications range from repairs to red tape to financing hurdles and beyond, so proceed with caution.
