What Does Pre-Foreclosure Mean?
What You Should Know
- Pre-foreclosure is the first step in the foreclosure process after a mortgage has been defaulted, due to missing payments or violating the mortgage agreement.
- The foreclosure process can only begin once a mortgage has been delinquent for 120 days or more.
- Pre-foreclosure is a period of time for borrowers to bring their mortgage out of default, such as through mortgage reinstatement, loss mitigation, or a short sale.
- The pre-foreclosure phase may last for 3-10 months depending on the state.
What is Pre-Foreclosure?
Pre-foreclosure doesn’t mean that you’ve lost your home just yet! Instead, pre-foreclosure means that your home is in danger of being foreclosed on by your lender. This can happen if you fall behind on your mortgage payments or if you break other terms of your mortgage contract resulting in a loan default.
Pre-foreclosure is the first step in the legal process, called foreclosure, that allows a mortgage lender to take ownership of the mortgaged property to recover the amount owed on the defaulted mortgage. During pre-foreclosure, the lender issues a Notice of Default informing the borrower that the lender is pursuing legal action towards foreclosure.
How many mortgage payments can I miss before foreclosure?
Typically, most lenders will initiate foreclosure proceedings after four months of missed mortgage payments. The number of missed mortgage payments that will result in foreclosure proceedings vary depending on the specific lender and state laws. It also varies based on your mortgage contract.
Federal regulations only allow mortgage servicers to file or issue a foreclosure notice once a mortgage has been delinquent for more than 120 days. This means that in most cases, you would need to have missed 120 days of mortgage payments before the foreclosure process can begin.
Missing one mortgage payment won’t immediately start foreclosure proceedings, but it is still best to avoid missing any mortgage payments. Missing mortgage payments can result in hefty late payment fees and negatively impact your credit score.
Defaulting On Your Mortgage
A mortgage default occurs when you violate the terms of your mortgage. One of the most common ways for borrowers to default on a mortgage is by failing to make their mortgage payments. This can happen for a number of reasons, such as losing your job or experiencing a significant decrease in income. One month of missed payments might not immediately cause you to default on your mortgage, but several months of missed mortgage payments may cause your lender to issue a notice of default. Missing payments will also rack up late payment fees, making it even harder to pay your mortgage. Some lenders may offer a grace period of 15 days after the due date before charging late fees.
There are other ways to default on your mortgage besides missing mortgage payments. This involves breaching your mortgage agreement, such as by failing to pay property taxes or homeowner's insurance, and neglecting maintenance on your home. These actions can threaten the value or ownership of your home. Since the home is being used as collateral for your mortgage loan, the lender will take action to protect its interest in the home and avoid any negative impacts to the value of its collateral.
Mortgage Delinquency and the 120-Day Rule
If you miss a mortgage payment, then your mortgage is delinquent. Even being one day late from your mortgage payment due date would mean that you are delinquent on your mortgage. However, lenders are not allowed to issue a notice of default or start foreclosure proceedings until you are more than 120 days delinquent. This is based on the Consumer Financial Protection Bureau's Real Estate Settlement Procedures Act (Regulation X) and the Truth in Lending Act (Regulation Z) Mortgage Servicing Final Rules.
Based on Regulation X, mortgage servicers cannot issue a foreclosure notice or start foreclosure proceedings until the borrower is more than 120 days delinquent. However, there are two other ways that foreclosure can begin before the 120-days are over. One way is for the borrower to violate a due-on-sale clause, which requires the borrower to repay the mortgage loan when the borrower’s home is sold. Violating a due-on-sale clause by selling a home that was mortgaged but not repaying the mortgage lender would allow the lender to immediately start foreclosure proceedings. The other way is for the mortgage servicer to join the foreclosure proceedings of a subordinate lienholder. This might be a second mortgage lender, a local government for unpaid property taxes, or even a homeowners' association for unpaid HOA fees.
How Pre-Foreclosure Works
Once a notice of default or notice of foreclosure has been issued, then the pre-foreclosure process starts. Pre-foreclosure properties are typically still occupied by the homeowners. As a homeowner facing foreclosure, what exactly does pre-foreclosure mean? The process of pre-foreclosure is designed to give the homeowners options to keep the property or sell it to cover the debt owed to the lender. During this phase, the borrower has some options to reverse the foreclosure process and keep the property.
Three common ways for a homeowner to reverse the mortgage default and stop the foreclosure process is to either catch up on late payments, work with the lender in a loss mitigation program, or sell the home in a short sale.
Catch Up on Late Mortgage Payments
A mortgage reinstatement is when you catch up on late payments and penalties to "reinstate" your mortgage. This brings your defaulted mortgage current and ends the foreclosure process. In order for a full mortgage reinstatement, the borrower would need to pay:
- Delinquent mortgage payments: This is the mortgage payments that were not paid. You will typically need to pay these mortgage payments at the interest rate that was effective on the mortgage payment's original due date.
- Late charges: You might have a grace period where you won’t be charged any late fees. Once the grace period ends, your lender may charge late fees. The amount of a late payment fee will vary based on your state and lender. It can either be a flat fee or it can be a percentage of the overdue amount.
You may even be charged late fees for mortgage insurance premiums. For example, FHA loans require FHA mortgage insurance premiums to be paid. Late fees for FHA mortgage insurance is 4% of the premium owed, with a 10-day grace period at the beginning of each month.
- Amounts that your servicer had advanced: Your mortgage servicer might have had to pay property taxes and insurance premiums on your behalf in order to keep the ownership of the home intact. You will need to repay your mortgage servicer for the amount that they paid on your behalf.
- Other related expenses: You might be required to pay your lender's or servicer's legal fees due to the foreclosure. The amount that you will be required to pay may depend on how far along you were during the foreclosure.
For example, Fannie Mae sets out milestones with an invoicing schedule. If your Fannie Mae mortgage was reinstated as soon as the title was requested, then you would only pay 30% of the foreclosure fee in connection to reimbursing legal and attorney fees. Waiting until the judgment is brought to court would require you to pay 90% of the legal and attorney fees.
Loss Mitigation Programs
Foreclosure is a costly and time-consuming process for lenders, which is why they are generally open to working with borrowers to work out a solution. In a loss mitigation program, a plan is made for the borrower to eventually repay overdue amounts. Some common loan modification plans include:
- Repayment Plan: The amount of the missed mortgage payments will be added to your future mortgage payments. You'll be able to repay the missed amounts over time, which is usually a period of several months.
- Forbearance Plan: A mortgage forbearance allows you to reduce or delay your mortgage payments. This might mean that you would not need to make any mortgage payments for several months while you get your finances in order. However, the missed payments will eventually need to be repaid. A repayment plan may be offered at the end of the forbearance period.
- Flex Modification: As a specific loss mitigation program offered by Fannie Mae and Freddie Mac, Flex Modification resets and extends your mortgage term to 40 years, reduces your mortgage's interest rate back down to current rates if your loan-to-value (LTV) is 80% or higher, and reduces your monthly mortgage payments by 20%.
A short sale is when the borrower sells the home for less than the amount still owed in order to pay the mortgage. The lender will need to agree to a short sale arrangement as there will be a portion of the mortgage balance that remains unpaid after the home sale. Some states with no anti-deficiency laws, such as Texas, Florida, and New York, allow deficiency judgements. This means that the lender can sue the borrower for the amount that they still owe after a short sale. If the property is worth more than the amount owed, the borrower may have an option to sell the property through a real estate agent or sell directly to a real estate investor instead of a short sale.
A deed-in-lieu of foreclosure is when the borrower transfers the title of the home to the lender. In exchange, the borrower is relieved of the mortgage debt. The lender will need to agree to a deed-in-lieu, and in some cases, the borrower may even be required to pay deficiencies if the home value is less than the mortgage balance due. However, just as with a short sale, the borrower will lose their home.
Pre-Foreclosure vs. Foreclosure
|Ability to Inspect the Property|
|Ability to Negotiate the Price|
|How It Is Sold||Off-Market||Public Auction|
|Length of Period||3 - 10 Months||6 - 54 Months|
Pre-foreclosure is the first phase in the foreclosure process. Foreclosure is the legal process by which the lender tries to recover the amount owed on a defaulted mortgage by taking ownership and selling the mortgaged property. During pre-foreclosure, the borrower has an option to reverse the default process by either catching up on missed payments or renegotiating the terms of the mortgage. During foreclosure, the lender is actively trying to sell the property and may not be willing to renegotiate the terms of the mortgage.
The timeline of the foreclosure process varies greatly state by state. Generally, the pre-foreclosure process starts when a notice of default is issued by the lender after the borrower exceeds the contractual terms for delinquent payments. Usually, a borrower can miss 4 payments before a notice of default is issued. The pre-foreclosure process may last for 3-10 months depending on the state. During this time, the borrower may have options to reverse the process of foreclosure. If the borrower does not take any action, the property goes into the foreclosure phase.
The timeline for the foreclosure phase varies greatly depending on the state, but the average number of days the foreclosure process takes is 830 as of Q3 2020. Judicial foreclosures also take much longer compared to non-judicial foreclosures. As an example, Florida and New York are judicial foreclosure states where lenders would need to file a lawsuit in court in order to be able to sell the home in a foreclosure. Non-judicial foreclosures do not involve the courts, and instead a series of notices are issued to the borrower, such as a notice of default and notice of sale. Nonjudicial foreclosure states include California and Texas.
During the foreclosure process, the property is placed for public auction and is sold to the bidder who offers the best terms for purchasing the property. If the property is not sold at the public auction, the lender becomes the owner of the property, and the property becomes Real Estate Owned (REO). At this point, the lender may either try to sell the property through a broker or through a REO specialist. When the property is sold, eviction, which is the last step in the foreclosure process, begins. The eviction process is quick and usually lasts for a few days.
Judicial vs. Nonjudicial Foreclosure States
Buying a Pre-Foreclosure Property
Pre-foreclosure properties are not necessarily for sale because the borrower may still have options to keep the property, such as by catching up on late payments or working on a repayment plan with their lender. On the other hand, when the pre-foreclosure property is listed on the market for sale for less than the mortgage amount due, then it is called a short sale, and it presents an enticing opportunity for homebuyers looking for a great deal.
There are three main reasons why an investor may consider buying pre-foreclosure properties:
- Pre-foreclosure properties are sold off-market, such as in a pocket listing or to a private network, so there is less competition to buy them.
- Pre-foreclosure properties are usually sold below fair market value, which allows real estate investors to get exceptionally good deals on the properties.
- The process of buying a short sale property is less risky compared to buying a foreclosed property because it is possible to inspect the property and conduct due diligence before buying the short sale. On the other hand, foreclosed properties are sold as-is without accepting any conditional offers in public auctions. You usually can’t have an inspection done before the auction, although some lenders may allow it.
To purchase a pre-foreclosure property, an investor has to take a number of steps that are described below.
1. Find an Appropriate Neighborhood
Before looking for a property, an investor may conduct a neighborhood analysis to identify suitable locations for an investor to invest in. Investing in up-and-coming neighborhoods may lead to home appreciation as home values rise in the area.
There are many different factors an investor may look at to identify a growing neighborhood. These factors may include:
- Growing retail businesses (coffee shops, restaurants, juice bars, etc.)
- Increasing rental rates in the area
- The demographic is composed of middle to upper-class individuals
2. Find a Pre-Foreclosure Property
One of the trickiest steps in the process of buying a pre-foreclosure property is to find the property because they are not listed in conventional real estate market listings like MLS. There are some ways to look for and identify potential pre-foreclosure properties:
- Look for pre-foreclosure properties online - Real estate marketplaces sometimes have pre-foreclosure properties listed by the owners in an attempt to sell the property faster.
- Post an ad for buying pre-foreclosure properties - A real estate investor may post advertisements in different marketplaces indicating that they are buying properties quickly and with cash, such as on Craigslist, which would be an enticing proposal for homeowners in pre-foreclosure.
- Check local newspapers for foreclosure notices - Before the property is sold at an auction during the foreclosure phase, the lender is obligated to generally publish a notice that the property will be auctioned. For example, this might be a public notice in a local newspaper that is published three weeks before the auction. During this time, it might be possible to negotiate a deal and to purchase the pre-foreclosure property before the auction.
- Drive around the neighborhood - Pre-foreclosure properties tend to be poorly maintained or even abandoned because if the owner cannot cover mortgage payments, then the owner is likely unable to cover the expenses that come with maintaining the property. An investor may look for a property that has neglected lawns, broken windows, and a poorly maintained outlook of the building. There is no universal guide about how to identify a pre-foreclosure property, so every investor should identify signs of potential pre-foreclosure property on their own.
- Mail and E-mail Campaigns - An investor may look into public records to identify and target people in financial distress. Generally, public records may be accessed through a local county assessor’s office. Investors look for certain kinds of information that will help them identify motivated sellers. Investors may be interested in old or out-of-state owners, absentee owners, and properties that have been on the market for a significant number of days. There are two significant problems with this method. First, public records may not be up to date, which lowers the chance of identifying current opportunities. Second, everyone has access to these records, so an investor does not gain a competitive advantage using this method. Mail and e-mail campaigns tend to be considered successful at a 1% response rate.
- Cold Calling - Just as for mail and e-mail campaigns, an investor may look through public records to identify potential sellers, get their names and phone numbers, and call them with an offer for their pre-foreclosed home.
3. Conduct Due Diligence
Assess the property
Unlike a property in foreclosure that is sold as-is, pre-foreclosure property can be evaluated before the purchase. An investor who finds an attractive property has an option to conduct due diligence on the condition of the house before choosing to proceed with the deal. This is an important step when purchasing a pre-foreclosure property because they tend to lack maintenance and may have problems that need to be fixed before the property can be considered habitable.
Calculate the Funds Required
When an investor has an idea of the property’s fair value and the costs associated with fixing the property, the investor can inquire about the outstanding debt on the loan through public records and even consult with real estate agents regarding the viability of the offer. It is important to conduct financial due diligence to make sure that the investor has the funds to cover all the expenses associated with the property including the offer price, assessment expenses, repair expenses, taxes, and any other surprise expenses that may appear when buying pre-foreclosure property.
Conduct Legal Due Diligence
An investor has to make sure that there are no liens or judgments against the property because as soon as the property is purchased, all associated liens and judgments become the responsibility of the new owner. The investor may consider hiring a legal team to make sure that the property is free from any outstanding liabilities. If the property’s title is clear, then it is considered to have a clear title. Outstanding liens, levies, and other issues would be called a cloud on title. Legal due diligence is an important step when buying a property in financial distress because it is likely that the owner may have other financial problems apart from the default on the mortgage.
4. Raise Capital
Pre-foreclosure properties tend to be sold for cash because it needs to be paid to the lender. This means that an investor needs to raise a substantial amount of capital to close the deal. If the investor does not have the funds to complete the transaction, one may have an option to get a loan. To get a loan, the investor needs to get a pre-approval letter from the lender that indicates the maximum amount the investor may get for the property. This letter can also work as proof to the original owner that the investor has the funds to complete the transaction. It is difficult and unlikely to get approved for a loan for pre-foreclosure property with a conventional loan, so the investor should try to qualify for a hard money loan.
You can also purchase a pre-foreclosure property with an FHA 203(k) loan. This combines the low credit score and down payment requirements of an FHA loan with the ability to receive financing to fund home repairs and renovations for pre-foreclosed homes. You can make a minimum down payment of as little as 3.5% if your credit score is at least 580. However, FHA 203(k) loans can only be used for properties that will be your future primary residence. It cannot be used to finance the purchase of investment properties.
5. Make an Offer
Making an offer is the final step in the process of buying a pre-foreclosed property. The investor has to pay off the mortgage debt owed to the lender and purchase the house from the current owner. The owner in financial distress is likely to accept the offer well under the fair market value of the property, which benefits the investor. Experienced investors usually look for pre-foreclosure houses that are significantly cheaper than their value by taking advantage of the owners in financial distress. Because of this behavior, there are laws in place that let the owner cancel the sale even after reaching a deal. The laws vary state by state, so it is important to look into it as a part of the due diligence process.
Once the deal is closed, there are a few steps the investor should undertake to ensure the property is protected. Many investors may overlook these steps and never suffer from them, but some choose to complete them to protect themselves from potential downsides:
- Change the locks - The previous owner may have kept the keys to the property, which makes it unsafe even when it is locked.
- Transfer the utilities to your name - The previous owner will cancel their utilities account, so it is better to get the account as soon as possible to avoid electricity and gas outages.
- Fix the property immediately - Don’t wait to repair the property. Some problems may lead to bigger damages that may put a strain on the investor’s cash flow.