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 by the previous owner.
In this article, we’re going to take a closer look at the risks associated with foreclosed properties and what you can do to eliminate them.
Types of Foreclosures
The three most common types of foreclosures in the United States are:
- Power of sale foreclosure
- Judicial foreclosure
- Strict foreclosure
A power of sale foreclosure, also known as statutory foreclosure, includes a power of sale clause in the mortgage contract. 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 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.
What are the Risks of Buying Foreclosed Homes?
Like 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 increases if you are buying at an auction where competing buyers may “spite bid” to drive the price higher.
To lower this risk, try setting a maximum bid at auctions and stick to a firm budget for off-market purchases.
2. You May Need Cash
Financing can be nearly impossible if you plan to buy a foreclosed property, especially if you plan to use conventional or FHA loan options.
You may be able to find a rehab loan with decent terms, but they can take significantly more time and 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
Like many investments, you’ll want to be sure that you’re making a proper return. In the case of foreclosures, novice investors are often unfamiliar with the potential expenses or costs involved.
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 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 Vague
A huge risk when buying a foreclosed home is that the sellers are not under any legal obligation to disclose major faults.
Foreclosed homes are generally sold “as-is”, meaning the full responsibility of due diligence is on the buyer. In other words, the buyer must arrange an inspection to ensure that the property does not have any glaring issues.
It’s always wise to keep a reserve of funds on hand in case the property needs considerable repairs – or even major overhauls 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 foreclosed homes 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 buyers 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 lender to lender and may require the home to be in a livable condition.
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.
Other options include government-backed loan programs from the Veterans Administration, Federal Housing Authority, or even the USDA.
Government-backed loans have the 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.
The Bottom Line
When it comes down to it, buying foreclosed properties may not be a bad investment – but they do have risks and benefits unique to foreclosures.
However, being aware of those risks can allow you to properly 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.
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