In this post we’ll explore the definition of pre-foreclosure, what pre-foreclosure means, how pre-foreclosures work, and how to buy a pre foreclosure home or property, and how pre-foreclosure sales work.
What Does Pre Foreclosure Mean?
In the world of real estate, pre foreclosure refers the period of time after a homeowner defaults on their mortgage loan but before the lender is legally allowed to start the foreclosure process.
At this stage, the homeowner still owns the property and has options.
- They can choose to make the back payments on the loan in order to get their mortgage back in good standing.
- They can negotiate a loan workout of forbearance
- With the lender’s approval, they can sell the property in a short sale.
Since this site is for real estate and note investors we’re going to focus more on how to invest in pre-foreclosures than how to stop pre-foreclosure.
How to Buy a Pre-Foreclosure Home or Property
For real estate investors, pre foreclosure presents an exciting opportunity to purchase property at the same deep discount they could a foreclosed property — without having to compete for the dwindling number of auction sales on the market.
Why invest in pre foreclosures?
The discount! Pre foreclosures are often sold for much less than foreclosures at auction.
Pre Foreclosure: An Introduction
Before the collapse of the housing market, borrowers had little recourse if they defaulted on their mortgage payments. In fact, nearly 10 million Americans lost their homes between 2006 and 2014. The glut of inventory became a contributing factor in the decline of housing prices, and that snowball just kept growing bigger.
Powerless to stop any of this from happening, Congress passed legislation designed to make it much more difficult for a similar crisis to occur in the future. The Dodd-Frank Act of 2010 tightened banking regulations and created the Consumer Financial Protection Bureau (CFPB). Among other things, the CFPB provides transparency to mortgage holders and has expanded consumer protections for homeowners on the verge of foreclosure.
How to Buy Pre-Foreclosures (2 Ways)
How to Buy a Pre-foreclosure from the Homeowner
The first way to buy a pre-foreclosure is the one with which most investors might be familiar which is you buy the property direct from the seller.
A pre-foreclosure may or may not be “underwater” meaning that the owner owes more on the property than its worth. When an owner is underwater and in pre-foreclosure this means you’re going to be involved in a “short sale”. A short sale means that the lender needs to agree to allow the owner to sell the property without paying off their loan in full.
Short sales add an additional layer of complication because the not only is the borrower not paying that borrower is also asking the lender to show forgiveness or leniency in the total amount owed. If the lender will not forgive the deficiency then there’s really no reason for the seller to cooperate.
Sometimes a pre-foreclosure property still has equity in which case you can ignore the short sale complication mentioned above. In this case making a deal is going to be all about how you contact the homeowner.
How to Contact a Pre-foreclosure Homeowner
The biggest tip I can give you in this case is that contacting a homeowner in pre-foreclosure requires EMPATHY. Sitting across from a homeowner who’s life is coming apart at the seams and who’s losing their home is no fun. For either of you.
The key to making a pre-foreclosure deal work with the homeowner is to look for a win-win. Often a win-win means that you do the negotiating with the bank and you get the homeowner some walking money.
This person is going to need to move somewhere, they’ll need a deposit, a moving truck, etc. You need to look at your numbers and decide how you’re able to help this person get more comfortably to the next step in their lives.
How to Buy a Pre Foreclosure from the Bank
When a property is in pre-foreclosure the property owner still has control. The owner continues to have the right to quiet enjoyment until the lender forecloses and repossesses the property at which point the property becomes REO.
So the bank cannot sell you a pre-foreclosure property. It isn’t theirs to sell.
What the bank does own is the “paper”. The bank owns the “note” the loan or the mortgage – whatever you want to call it. Notes are negotiable instruments, meaning they can be traded – bought and sold – just like real estate.
Lenders can sell you the note on a pre foreclosure property. Yes, you can be the bank.
The way this works is that, rather than contacting the property owner in distress you contact the lender to whom the borrower has defaulted. When you buy the note and its non-performing you, as the lender now, have the right to collect what’s owed to you according to the terms of the note.
Buying the note means you can go “upstream” to get pre-foreclosure property. Once you own the note you may be able to do loan modifications or workouts that an institutional lender simply cannot do and because you’ll buy the note at a discount the deal will still be profitable.
If your goal is still to own the property then once you’re the lender of record and the property is in default you foreclose on the note (less complicated than it sounds). At the foreclosure auction you make a “credit bid” as is your right, up to the full amount owed including default interest and other fees and penalties. If you bought the loan at a discount then your credit bid can be significantly higher than for the amount that you’re actually into the deal.
Once you complete the foreclosure sale you, as the lender, now own the real estate.
That’s how you go upstream for pre-foreclosure deals.
More About Pre-Foreclosure
How Long Does Pre Foreclosure Last
In a way, pre foreclosure is the legacy of this new regulatory climate. Lenders must now wait 90 days before they can issue a Notice of Default, the official document that places a property in pre foreclosure. At this point, homeowners still have time to make back payments and negotiate with the lender over the terms of the mortgage. Depending on the state where the real estate transaction took place, there may be additional requirements placed on the lender to disclose information or work with the delinquent homeowner.
Loan modifications, which make the loan payments more affordable, are not always possible, though. A homeowner must be able to point to a hardship that led them to default. Moreover, some of the key programs that helped homeowners to afford their loan payments, such as the Home Affordable Modification Program and the federal Home Affordable Refinance Program (HARP), have expired now that the worst of the housing crisis is over.
Although the pre foreclosure period gives delinquent homeowners time to think about their options, it doesn’t change the inevitable for many Americans. Pre foreclosure is already an officially recognized default, and a significant percentage of properties will slip into foreclosure unless a buyer steps in to negotiate a sale.
In this sense, pre foreclosure is the new foreclosure. The most recent data shows that auction sales only comprise 47.3 percent of homes in varying states of delinquency. The other two categories, pre foreclosure and real estate owned (REO) properties, are 31 percent and 21.7 percent respectively. The majority of distressed homes on the market, in other words, are not foreclosures.
The Pre Foreclosure Timeline
The timeline varies from state to state because each state can determine its own rules regarding foreclosure and pre foreclosure. But some basic steps are common to all mortgage loan defaults.
- Notice of Default
Although lenders start keeping track of delinquencies after the homeowner’s first missed payment, sending notification to the credit bureaus, they are not allowed to issue an official notice until the note is 90 days overdue. The Notice of Default is a public document that is typically sent to the homeowner via certified mail.
The Notice of Default lets the homeowner know how much they owe, usually a combination of back payments and fees, to make good on their contractual obligation. It may provide the homeowner with a grace period, or it may simply be a final notification that the foreclosure process is now underway. Most state provide the homeowner with a set period of time in which they can “cure” the loan, or make back payments.
- Legal Filing
If the homeowner doesn’t satisfy the lender’s requirements by the stated deadline, they may then elect to proceed with the foreclosure. Again, each state has slightly different requirements. And to complicate matters further, there are two types of foreclosure, judicial and non-judicial.
In a judicial foreclosure, the lender files with the court to get an order allowing them to sell the property at auction. A non-judicial foreclosure allows a trustee — i.e., the lender — to follow the procedures spelled out in the mortgage contract without having to first obtain the court’s permission.
As a general rule, lenders are not allowed to start foreclosure proceedings until the loan is 90 days overdue. Despite the fact that foreclosure is imminent, in many states the homeowner can still make good on the loan up until the time of auction.
- Notice of Auction Sale
Once the loan is a past due by a certain amount of time, typically 120 days, lenders in most states will issue a notice of sale. This document tells the homeowner when the property will be sold at public auction. The notice may be sent to the homeowner via certified mail, and it might be published in the local newspaper or at the county courthouse.
The notice provides homeowners with the date they must vacate the property and could also include the total amount in arrears as well.
- Public Sale
At this point, the property passes from pre foreclosure to foreclosure, as the bank repossesses the property. The lender either sells the property to the highest bidder at public auction or elects to purchase the property themselves by submitting a credit bid on the approximate amount due on the mortgage. They may elect to sell this REO property at a later date.
Pros and Cons of Buying a Pre Foreclosure
No matter which state you want to purchase property in, there is a long window of time in which the lender hopes to recoup as much money from the broken contract as possible, while the homeowner seeks to avoid ruining their credit. Thus, pre foreclosure presents a golden opportunity for real estate investors, who are positioned to help both the lender and homeowner to achieve their objectives.
The biggest positive in buying a pre-foreclosure is you may be able to purchase the property as a short sale, meaning that you can acquire it for less than its market value. After the collapse of the housing market, many mortgages across the United States were “underwater”; however, it’s important to recognize that not every pre foreclosure qualifies as a potential short sale.
If you can find such a property, the lender may be willing to grant approval for a short sale; these transactions translate into more compensation for them than loan modifications. And if the delinquent homeowner cannot make good on the amount in arrears, they will also be happy to discharge their financial obligation without the punitive hit to their credit score that a foreclosure brings.
The result is you get a property at a discount, and the lender and delinquent homeowner make the best of a bad situation. It’s a win for everyone.
Well, most of the time it is.
Pursuing a pre foreclosure does involve a certain amount of risk. The same legislation put in place to protect homeowners in default gives some sellers the right to rescind on a real estate transaction. And it can be tough to negotiate with sellers in default. They may not want to part with the property and could have unrealistic expectations. Negotiating with the lender can also be problematic since, technically, the property still belongs to the seller.
As with any distressed property, pre foreclosures may have structural damage that eats away at your profit margin. Although you have the right to order an inspection on a property that is making its way through the foreclosure process, the very nature of pre foreclosure makes that a risky proposition. If the homeowner accepts a loan modification or makes their back payments, you are out the inspection fee. This can add up if multiple properties are involved.
On the other hand, without an inspection report, it becomes difficult to access the nature of the damage and the cost to repair and remodel the property for resale. Being able to do a walkthrough with your contractor is probably the best-case scenario. Nevertheless, as one sees on home improvement programs all the time, some problems only reveal themselves when the remodeling is underway.
Unless you have a fair degree of experience in home repair, you could end up sinking so much money into the pre foreclosure that you lose money on the entire deal.
Some Final Thoughts
Pre foreclosure is a period of limbo for both lenders and delinquent homeowners. Regardless of the amount owed on the mortgage, whether it is “underwater” or has some equity, there is an urgent need to sell whether or not the homeowner recognizes it. The lender is also predisposed to allow a sale because selling the home is less costly to them than allowing things to progress to foreclosure.
Thus, real estate investors should consider pre foreclosure one of the first, if not the first, opportunity to expand their portfolio of distressed properties. Finding pre foreclosures is one thing; finding a profitable pre foreclosure and entering a successful negotiation with either the lender or the seller is another. For those who understand the market and have excellent powers of communication, however, this can be a highly lucrative approach to buying real estate.