Last updated : Wednesday, March 25, 2009

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Buying a Foreclosure

Home with foreclosure sign in front yard

Yes, foreclosed homes might sell at only a small percentage of their market values, giving buyers ample opportunity to make promising investments. But like any good deal, there's often a catch. If you aren't prepared, you could end up losing money, and acquiring a whole lot of drama.  

Foreclosures are homes that have been seized by the bank due to negligence of payment on the owner's part, and there are many issues that can arise throughout the process that you might not encounter during a traditional real estate transaction.

First, there are three stages of foreclosure where there is an opportunity to buy. It's important to know the differences among them.

1. Preforeclosure: The owners of the home have fallen behind on their mortgage payments, usually by 90 days or more. While the lending institution has not yet seized the property, it files a Notice of Default, which essentially starts the legal process of taking the home. The owner then has a short window to resume payments before the bank takes ownership and puts the home up for sale. Experts say that this is probably when you'll get the best deal. "You are saving a homeowner from having a foreclosure on their record," says real estate analyst Dani Babb, founder of The Babb Group. "Foreclosing on a home costs a bank about $50,000; if the home is priced low enough, the bank would rather short sale (selling before it is foreclosed on) than foreclose."

Pros: Because you are working with the homeowner, you are avoiding open market competition and you might be able to negotiate a favorable price. You also may have time to research the title and find comparable market prices.

Cons: The home is being sold "as is," meaning if there are any damages to the home, you will be responsible for them. The title of the home might be tagged with judgments for second mortgages, loans, late fees or other fines, which you would also be responsible for. Short sales can take anywhere between three to six months.

2. Real Estate Owned (REO): The owners of the home failed to pay their outstanding mortgage payments, and the lending institution has assumed ownership of the property. It is now the lending institution that is selling the home, not a private owner.

Pros: Because the bank owns the property, they might be more likely to finance it. You also have more time here to inspect the home and research its title.

Cons: The banks will want the most they can get, so you might not get the best deal, and there is generally little negotiation room on price. "The banks treat properties as lots, not as individual properties," says New York real estate lawyer Nathan Erlich, of Nathan Erlich, P.C. "They then have companies deal with the lots, and the companies hire a lawyer, which turns into much of a bureaucracy. It's hard to negotiate with them. It's very black and white and it leads to many risks when you're forced to sign a contract like that."

3. Auction: No one bought the home from the lending institution or bank, and the bank wants to get rid of property as quickly as possible. The bank puts the home up for auction, where anyone can come bid on the property. While the price might seem too good to be true, the purchase itself can be incredibly risky. "This is a dangerous place to buy a foreclosure often because you may have to put money down--as much as five percent just to walk in the auction house and you may not get a chance to see the home beforehand," Babb warns.

Pros: Prices will be the most reduced.

Cons: This is by far the riskiest way to buy a foreclosure. You are competing with experienced investors, who know the ins and outs of buying foreclosed properties. You cannot inspect the property, or do any research on comparable prices. Some of these homes have been empty for a while, so the likelihood of damage is high. You do not receive title insurance, and you are responsible for any additional tax liens. Most important, you have to pay in cash or with a cashier's check, and ALL SALES ARE FINAL.

Be prepared

Buying a foreclosed property is undoubtedly a risky and a often time consuming process.
If you are set on buying a foreclosed home, Babb says you should have a comprehensive package ready to ensure you get the home, and get it at a good price.

-Have good credit: "You can get a loan with a 680 FICO, but you will get your best rate at 740 or above. If you buy a conventional home the mortgage rates are about 5.25 percent right now--a jumbo is about 2 to 3 points higher in interest."

-Liquidity: "Be sure that you have 20 percent down, and be sure you have one to two percent of the price to give as an 'earnest deposit'. This is refunded if you don't get the house, but not if it is your fault, so be sure you can buy what you write an offer for!"

-Have a pre-qualification and pre-approval letters. "Get both, if possible for short sales or REOs. This will make your total package look better than others and that is important."

-Do your homework for the area. "Make sure that there aren't a lot of homes with lock boxes on the door and no signs outside. This is a sign that the bank took the home back, but hasn't listed them yet and the homes in the area could continue dropping in value."

-Check comparable market prices. "Make sure that you do diligence and check what the comps are going for in the area so you aren't overpaying. If you are buying a preforeclosure, it might help to work with a short sale agent who knows how to package these types of deals; banks require different types of information, even letters of community service can help!"

Be aware

Once you have qualified to buy the home, make sure you stay involved in the contract process. "You have to negotiate the shortsale contract carefully," says Erlich. Here are his tips on what to look out for:

-A determined closing date

-"Time is of the essence" clause: "This is an extremely dangerous term in a contract. If you don't close by a certain date, you could lose your deposit."

-Banks that want you to use their title insurance company

"I'll make sure to knock that clause out. Many banks have deals with certain title companies. It's illegal to force someone to use a particular insurance company. You might say, 'Who cares as long as I have title insurance?' Well, title insurance companies are operated under a ratings system. Some have A's, some have B+'s, some have B's. Title insurance costs the same no matter where you get it. So why should my client have a B-rated company when they could use an A+ rated company?

You want to pick an insurer with whom you have a solid relationship. That way, down the road when you want to sell the home, if there are issues you can contact them directly."

-"As is" clause. "This basically says 'what you see is what you're buying.' When you buy a home in the traditional process,there is a clause that says the plumbing, electrical and mechanical must all be in 'working order' and the roof must be free of leaks. This clause does not exist when you are buying from a bank." (*This varies state-to-state).

-Vacant house. In this time of confusion with the economy so bad, people have become desperate and crime has gone up. When you are buying 'as is', that's 'as is' at the time of contract signing. If damage occurs between that time and the time you close, you are liable."

-Evictions. These are people's homes where they brought their children up. It's their life. And now the bank comes along and takes their homes away, and people are bitter about it. Many times, it will go to the stage where the police will have to go to the home and take the furniture and the people out of the house and put a new lock on the door. At times you have people pour cement down drains and take revenge, and if you can't inspect the home, you always have to be wary of that."

 

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