What does pre-foreclosure mean and how to buy a pre-foreclosure home?

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What You Should Know

  • Pre-foreclosure is the first step in the legal process that allows a mortgage lender to take ownership of the mortgaged property to recover the amount owed on the defaulted mortgage.
  • Pre-foreclosure starts with a Notice of Default issued by the lender.
  • The pre-foreclosure process may last for 3-10 months depending on the state.
  • The borrower has options to reverse the process of default during pre-foreclosure. These options include mortgage reinstatement, loss mitigation, and a short sale of a mortgaged property.
  • A short sale allows the borrower to avoid damaging their credit history by paying off debt through selling the property, but the property is sold at a lower price than fair market value.
  • Pre-foreclosure property is not necessarily for sale because the borrower may still have the options to keep the property.

What is pre-foreclosure?

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. Pre-foreclosure occurs most often when the borrower misses on average 4 months of payments on the mortgage, or when the borrower fails to meet other terms of the mortgage agreement.

Foreclosure Timeline

What does pre-foreclosure mean to the borrower?

Pre-foreclosure properties are typically still occupied by the homeowners. 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.

  • The borrower may catch up on late payments by asking the lender for reinstatement, which includes all missed payments and penalties and receiving a grace period of 30 days to pay off the amount owed.
  • The borrower may also request loss mitigation from the lender, which could mean forgiveness of a part of the loan or renegotiated terms of the mortgage. The lender is not required to proceed with this option, so it may not be a viable option in every case.
  • The borrower also may have an option to arrange a Short Sale of the property before the foreclosure process begins. A short sale happens when the amount owed by the borrower is larger than the market value of the property. 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.

Pre-foreclosure vs. Foreclosure

DescriptionPhase the Property Is In
Pre-foreclosureForeclosure
Ability to Inspect the PropertyYesNo
Ability to Negotiate the PriceYesNo
How is it SoldOff-marketPublic Auction
CompetitionLessMore
Length of Period3 - 10 months6 - 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. Unlike during foreclosure, 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 the foreclosure process, 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 at the Notice of Default that is issued by the lender 90 days after the borrower exceeds the contractual terms for delinquent payments. Usually, a borrower can miss 4 payments before the 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 gets 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. 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 on a 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 lasdts for a few days only.

How to buy a pre-foreclosure property?

Pre-foreclosure property is not necessarily for sale because the borrower may still have the options to keep the property. On the other hand, when the pre-foreclosure property is listed on the market for sale, it is called a Short Sale.

There are three main reasons why an investor may consider buying pre-foreclosure properties:

  1. Pre-foreclosure properties are sold off-market, so there is less competition to buy them.
  2. Pre-foreclosure properties are usually sold below fair market value, which allows investors to get exceptionally good deals on the properties.
  3. 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 while the foreclosed property is sold as-is on auctions.

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 developing neighborhoods may lead to appreciation of the properties 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 Markets 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 - An investor may post advertisements in different marketplaces, such as Craigslist, indicating that they are buying properties quickly and with cash since the borrowers with pre-foreclosure properties try to sell quickly and for cash.
  • 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, in a local newspaper for three weeks before the auction. During this time, it might be possible to negotiate a deal and get the 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, the owner is likely to not be able 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.

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 fair value of the property 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. This 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.

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.

Post-Closing Considerations

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.
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