The Pros and Cons of Buying a Foreclosed Home

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One way to look at the purchase of a foreclosed home is that one person's misfortune is another's opportunity, and in a dog-eat-dog economy, that's a common viewpoint, although the reality is, of course, almost always more complex. At any rate, as the potential purchaser of a foreclosed home, you have to be aware of what you're getting into because purchasing a foreclosed property isn't the same as a conventional home purchase.

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You may have fallen in love with the property at first sight, but the seller — a bank or mortgage company — is typically a disinterested third party and won't share your enthusiasm. A foreclosure purchase is usually "as is," and while some banks take efforts to make the house presentable, they won't do major repairs to plumbing, electrical or HVAC systems, and you'll have to do those before you can move in.

The possible need for extensive repairs is just one of the hazards of a foreclosure property purchase, but there are obvious benefits as well, not the least of which being the acquisition of your dream home for pennies on the dollar. Foreclosures are attractive to investors too and probably more so because they can be fixed up and sold for much higher prices. With the benefits of potentially huge cash savings, though, comes considerable risk.

What's Involved In a Foreclosure?

The foreclosure process can be a long one, often lasting over a year depending on how quickly the bank acts. During this time and often even after the foreclosure is official, the homeowner may continue to occupy the property.

The foreclosure process has six distinct phases:

  • The homeowner misses a mortgage payment. This is known as a default.
  • The bank issues a notice of default, and in some states even tacks this notice on the front door or some other prominent place on the building. The earliest this can occur is 90 days after default, but many lenders wait until the homeowner has missed two or more mortgage payments. The notice of default is often followed by a 90-day reinstatement period during which the homeowner has a chance to correct the default. The total time elapsed so far is six to eight months.
  • The bank publishes a notice of trustee's sale in a local newspaper for three weeks and announces a public auction.

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  • A foreclosure auction is held, and if there's a successful bidder, that person becomes the new owner. If the home doesn't sell at auction, the bank assumes ownership, and the home becomes an REO (or real estate owned) property. During the REO period, the original owner may be allowed to stay in the home.
  • The bank sells the property and sends an eviction notice to the occupants of the property. They must vacate the premises on receipt of the notice or soon afterward.

The REO period can stretch into a year or two or more depending on the housing market and the amount of the unpaid loan. The bank's primary interest is to recoup its losses, and if the market is sluggish and the loan balance is large, it may elect to hold the property until conditions improve.

How to Find a Foreclosed Home

Some lucky people find the home of their dreams by scanning the classifieds, going to an auction and paying for the home in cash, but most people do it by working with a real estate agent to purchase an REO property. A good agent will have a complete listing of all the REO properties in the area, but if you're in the early stages of the search and don't yet have an agent, you can find leads on Zillow, which lists foreclosures and pre-foreclosures, which are foreclosures still in the default phase. In addition, the Department of Housing and Urban Development also maintains a searchable database of foreclosed homes, as do Fannie Mae with its HomePath program and Freddie Mac with HomeSteps.

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How to Buy a Foreclosed Home

If you know of a distressed property, you may be able to purchase it during the default or pre-foreclosure phase by making an offer to the owner. An offer below the market value of the property but at least large enough to cover the unpaid part of the mortgage may be accepted. This is known as a short sale, and it must be approved by the lender, who is often motivated to avoid the costly and time-consuming foreclosure process.

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If the bank won't approve a short sale, the next opportunity to purchase that foreclosed home is at the foreclosure auction. The problem with this strategy is that cash offers are usually required at auctions, and when they aren't, you must have a certified check for a predetermined amount (usually $5,000) in hand and loan preapproval just to make a bid.

Large investors with deep pockets are the ones most likely to have this type of cash on hand, and that's against whom you'll be bidding, especially if it's a valuable property. Another problem is that homes are sold in "as is" condition at auction, and you can't inspect the home if it's still occupied. A third problem is that the title may not be clear, and the buyer has to clear up any problems with it, such as outstanding liens.

Most people who buy foreclosed homes do it after auction when the bank has repossessed the property and assigned it to an REO real estate agent. This is safer than buying it at auction because the bank does the work of clearing the title and evicting the current occupants. An REO property is usually sold "as is," but the bank usually provides the opportunity to conduct a home inspection. To purchase a foreclosed home this way, it's best to hire a real estate agent who has experience dealing with REO real estate agents and foreclosed homes.

Reasons to Buy a Foreclosed Home

The first and foremost reason to buy a foreclosed home is to save money. Foreclosed homes often sell for less than they are worth, and you could end up saving as much as 15 percent of the price you would pay if you were to buy the house on the open market.

Things don't always work out that way, but they might, and the possibility is a big incentive, especially for first-time homebuyers seeking to move into a neighborhood they couldn't otherwise afford. If you're an investor, purchasing a house for less than it's worth also means you may be able to do the necessary repairs if they aren't extensive and resell the house for a handsome profit.

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You'll probably face less competition from other potential homeowners when making an offer on a foreclosed home than you would when purchasing from a private seller. Forty-eight percent of homebuyers are looking for a turnkey home that they can immediately occupy, and few foreclosed homes meet that standard. You could, on the other hand, face plenty of competition from investors if the property is a good buy, but if you love the property and are interested in more than making a profit, you'll be willing to bid higher than an investor.

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Reasons Not to Buy a Foreclosed Home

There's a whole list of reasons you might not want to get involved with a foreclosed property, and you need to weigh them against the financial benefits. Of course, if you're just in love with the home and it's in your ideal neighborhood or it meets a need no other available house can meet, those might be the deciding factor. If not, consider the following:

  • You buy the house "as is."​ The house could be in good shape, slightly run down or severely damaged, and you aren't always allowed to have a home inspection. The previous owner is often understandably upset after going through a foreclosure and may express the upset in destructive ways. Stories exist of people putting cement in the drains prior to eviction, but even if nothing like this happens, it's a sure bet that the previous owner will neglect major repair issues.
  • You may have to wait to move in.​ When a home is purchased at auction, it's the successful bidder's responsibility to evict the current occupants, and that can be difficult — especially if you happen to be living through a pandemic — and it's time-consuming. If an REO property has been standing empty for several years, it may be occupied by squatters who can legally have the same rights as tenants in certain circumstances. Besides the delay caused by an eviction, which can be several months, you'll also face one from the bank, which can often take its time to process the sale.

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  • You might not ever move in.​ You could be walking to the real estate agent's office to sign the closing papers when the previous owner suddenly finds the money to pay off the loan, and the sale is off. Some states even give homeowners the right to redeem their property after a foreclosure sale, so you can still lose the house even if the sale closes.
  • It might be harder to get a loan.​ Because of the potential for damage, lenders consider foreclosed homes to be high risk, so you may need a higher credit score and/or down payment to get a loan. If you have poor credit but you qualify for a Federal Housing Administration (FHA) loan, you might still be out of luck because some foreclosed properties are ineligible for FHA loans.
  • You're competing with investors.​ When you're searching the conventional home market, the competition is mostly people like you who just want to find a place to live. The competition you face when searching for foreclosed properties is mostly investors looking for a turnaround. They will drive up the bidding, and you may end up paying almost as much as you would for a home that isn't under foreclosure. Add on renovations and the house could cost even more than that.

The Bottom Line

If you purchase a foreclosed house at auction, you'll probably pay less for it than you would at other times in the foreclosure process, but because you can't do an inspection, purchasing at auction is risky. There are two safer alternatives. One is to purchase a home in the default or pre-foreclosure phase, when the homeowner is still doing the negotiations and is motivated to sell. The other is to purchase an REO property through a real estate agent.

These alternatives are safer because:

  • You take possession of an empty house (assuming the absence of squatters).
  • The house is more likely to be in a reasonable state of repair.
  • You can finance the property with a conventional mortgage.
  • The deed will be clear of liens, back taxes and other encumberments.

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Chris Deziel is a contractor, builder and general fix-it pro who has been active in the construction trades for 40 years. He has degrees in science and humanities and years of teaching experience. An avid craftsman and musician, Deziel began writing on home improvement topics in 2010. He worked as an expert consultant with eHow Now and Pro Referral -- a Home Depot site. A DIYer by nature, Deziel regularly shares tips and tricks for a better home and garden at Hunker.com.