There are few investments better than real estate; however, all investments carry some degree of risk by nature. This risk is even more prominent in investments like real estate, which has incredibly low liquidity.
While many investors look at real estate acquisition as relatively safe, this can change drastically when buying a property that was foreclosed on from the previous owner.
In this article, we’re going to take a closer look at just what makes buying a foreclosed property risky, and if there’s anything you can do to reduce or eliminate those risks.
Types of Foreclosures
The three most common types of foreclosures in the US are:
- Power of sale foreclosure
- Judicial foreclosure
- Strict foreclosure
For a power of sale foreclosure, also known as statutory foreclosure, the mortgage contract in some states will have a power of sale clause. This makes it possible for the lender to auction the property off to fulfill the foreclosure. This does not require any judicial involvement and is allowed in a total of 29 states.
A judicial foreclosure requires the lender to file a suit to begin foreclosure proceedings. This is then communicated to the buyer, and they are usually given 30 days to become current on the loan. If that fails, the property is then auctioned off by either the county sheriff or a court.
Strict foreclosures are only allowed in Vermont and Connecticut and require a suit filed by the lender against the defaulted borrower. The court then sets a time limit to pay the mortgage, and if that fails, the property title transfers to the lender automatically.
This is the only type of foreclosure that doesn’t require a formal sale.
5 Risks of Buying Foreclosed Homes
As with any investment, buying a foreclosed property comes with certain risks that you as the buyer should be aware of.
1. Overpaying Is Easy
A common risk when buying a foreclosed property is paying more than the current market value of the home. This risk can be exacerbated if you are buying at an auction, where competing buyers may “spite bid” to drive the price higher.
You can lower this risk considerably by setting a maximum bid at an auction, or setting a firm budget for yourself when buying off-market
2. You May Need Cash
Financing can be nearly impossible if you plan to buy a foreclosed property, particularly if you plan to use conventional financing options or an FHA loan.
You may be able to find a rehab loan with decent terms, but they can take significantly more time and can make a flip uneconomical. That being said, some lenders will have options available for these types of situations.
3. Your ROI Can Take an Unexpected Hit
Many novices aren’t familiar with the potential expenses or additional costs associated with buying a foreclosure.
While most will be prepared for the property price and a standard title fee, there may be unexpected costs as well. There may be transfer taxes or even liens on the property, and you may even need to pay fees related to the original foreclosure.
4. Your Rental Plan Can Be Delayed
Buying foreclosed homes risks delays brought on by the process of buying a foreclosure.
Foreclosure sales are known to have more delays than traditional sales, particularly during the escrow phase at closing. One way to minimize these delays is to make sure you’re working with an experienced broker or real estate agent.
Your agent should not only have familiarity with foreclosure sales but also with the financial institution involved in the transaction.
5. As-Is Sales Can Be Nebulous
A huge risk when buying a foreclosed home is that the sellers are not under any legal obligation to disclose major faults.
The homes are generally sold as-is, meaning the full onus of due diligence is on the buyer, and the buyer must arrange for their licensed inspector.
It’s always wise to keep a reserve of funds in case the property needs considerable repairs or even major expenses like roofing or foundation work.
Benefits of Buying a Foreclosed Home
The primary benefit of buying a foreclosed home is that you can often pay considerably less than market value if the right circumstances exist.
While they may not necessarily have a listing price that is lower than other area homes, they are priced by the lender, who wants to sell the home and get it off of their books.
Can You Get a Mortgage to Buy a Foreclosed Home?
It’s not uncommon for a buyer to be able to obtain a mortgage for the purchase of a foreclosed home. Many lenders even specialize in loans for foreclosed properties or properties that need rehab.
The terms of the loan will vary from one lender to another, and some may require the home to be in livable condition, while others won’t.
Before you begin your property search, you may want to apply for a mortgage ahead of time to obtain a pre-approval, which can substantially increase the odds of the seller accepting your offer.
Mortgage Options for Buying Foreclosed Homes
In many cases, even when a property is foreclosed you can leverage a variety of conventional mortgage options.
As long as you aren’t buying from a cash-only auction, and provided the home is in livable condition, you may be able to get a conventional mortgage.
Government-backed loans have a major advantage of making a home more affordable, though they do come with some stipulations depending on the property.
For example, if the property you’re looking at isn’t able to qualify for a loan due to not being in “livable condition”, it may require some additional work to be performed before it meets the minimum criteria.
On the other hand, since you don’t need mortgage insurance with government-backed loans, you could use the money saved there for further work.
When it comes down to it, while buying foreclosed properties may not be a bad investment, they do have risks and benefits unique to foreclosures.
However, knowing what you’re facing when it comes to those risks can allow you to much more adequately prepare.
One of the best ways to go into a foreclosure sale is to visit a lender today and start the process of pre-approval, so you can start seriously start looking for your next investment.