How Foreclosures Work

The Foreclosure Process

The foreclosure process is different from state to state. This is how it works in California.

Once you are 30-days delinquent on your mortgage payment, your lender has the right to file a Notice of Default. When this notice is filed, the foreclosure process technically begins.

Although they can file this “NOD” after 30 days, in practice, most lenders aren’t getting around to filing a Notice of Default for much longer. It isn’t uncommon for 6 months or more to pass without an NOD being filed, simply because the banks are overwhelmed.

The NOD is public record and once it has been filed, homeowners can expect to be solicited by all kinds of “ambulance-chasing” service providers – from lawyers, to real estate agents, to mortgage brokers, to “investors” offering to buy their house. Sometimes people refer to homes in this situation as “pre-foreclosures” properties. The property will also show up on websites that track foreclosures such as ForeclosureRadar and RealtyTrac.

In California, lenders have to wait 90 days after the Notice of Default is filed until the can file a Notice of Trustee Sale. This “NTS” officially defines a date that the property will be “sold” on the courthouse steps. This sale date must be at least 21 days after the NTS filing date. Often, people refer to these as “auction” properties.

In theory, a home could have an NOD filed after 30 days, and NTS after 90 days, and be “sold” (or repossessed) 21 days after that. However, in practice, it doesn’t usually happen that fast. In fact, LPS (a major Asset Management Company) recently reported that homes foreclosed upon in August of 2011 were delinquent for an average of 661 days.

Foreclosures are taking a long time for a host of reasons:

• There are lots of delinquent loans and banks are overwhelmed
• Banks will stop the process if you are attempting to modify your loan (and even if you get rejected from HAMP, the whole process could delay your foreclosure for a year).
• Banks will typically stop the process if you are trying to sell your home.
• Banks will stop the process for a while if you file bankruptcy.

Preventing Foreclosure

From the time a borrower misses their first payment, all the way up until right before the sale date on the courthouse steps, they can usually stop the foreclosure process by paying the amount owed to bring the loan current. For some, this is an option. For most, they need to consider some alternatives.

Loan Modifications

If a borrower wants to keep their home, then a loan modification may be their only option. They may qualify for a HAMP, government-sponsored modification. Or, they might have better luck dealing directly with the lender.

Lenders will typically modify a loan by reducing the interest rate and/or extending the term (to 40 years, for example). Unfortunately, very few lenders are reducing the principal (the total amount owed) of mortgages at this time. The only notable exception is that Wells Fargo has been proactively reducing principal on Option-Arm loans in the portfolio that it inherited from One West Bank via Wachovia. If you got an Option-Arm loan from either Wachovia or One West Bank, you might be in luck.

Short Sales

If a borrower doesn’t want to keep, or can’t afford to keep the house, then a short sale may be their best option. A short sale is when the net proceeds from the sale are less than what the lender (or lenders) is owed. To complete the sale, the lender would need to agree to remove the additional lien from the property so it can transfer to the new owners. That lender, then, can either agree to forgive the remaining debt, or try and collect from the borrower.

To learn more about short sales, read How Short Sales Work

Deed In Lieu of Foreclosure

A Deed In Lieu of Foreclosure is effectively a foreclosure without the headache. In the document, you agree to surrender your ownership rights to the bank. You move out. You’re done.

To a lot of people stuck in foreclosure-limbo, this actually sounds pretty good. The problem is that banks will generally not offer you a Deed In Lieu unless you have tried for a long time to do a short sale first.

What is the Best Foreclosure Alternative?

For most consumers, the biggest concern is how each option will impact their credit. There are two points here to consider: the overall impact on your credit score and how long you will have to wait before you can get a mortgage again.

Though each situation is unique, FICO reports that the difference in credit scores between a someone with a foreclosure on their credit, versus someone with a short sale or Deed In Lieu, is about 40 points.

As far as how long a borrower would have to wait until they can get a mortgage again, current “blacklist” periods are  5 years for a foreclosure, and 2-3 years for a short sale or Deed In Lieu (depending on overall credit, down payment, and any circumstantial issues).

I would caution, however, that these blacklist periods could get shorter or longer in the coming years.

Understanding Strategic Default

A “strategic default” is when a homeowner voluntarily goes into foreclosure on a home that they can afford. These homeowners are usually underwater and choose to walk-away from their homes to get out from under the excessive debt, regardless of how affordable their monthly payments might be.

From a socioeconomic perspective the willingness of homeowners to walk-away from their homes could be the single most-important driving factor in the housing market over the next 3-4 years. If people are generally optimistic, more homeowners will try and hold on. But, if social mood continues to darken, more homeowners may choose to give up. Things could quickly spiral out of control.

If you are in this situation, please take the time to research all of the tax, collection, and legal consequences of walking away. Just because “everyone’s doing it” doesn’t mean that you won’t end up in trouble. If you aren’t sure where to start, I would recommend reaching out to my friend Jon Maddux at You Walk Away.

You will also likely be better off trying to do a short sale on the property. If you are in the Bay Area, I can help. Otherwise, find a local real estate agent with short sale experience.

Deficiency Judgments

In a foreclosure, the liens are removed from the property, but that does not mean that the borrower isn’t still liable for the debt. For example, say a borrower owes $600,000 on a property and the bank “forecloses” on that property for $400,000 on the courthouse steps. The borrower may be liable for that extra $200,000.

Some states, like California, require that many first-mortgages on primary residences be “non-recourse” – meaning that the lender does NOT have the power to collect debt beyond what the collateral (the house) covered. Other states, notably Florida, allow for more “recourse” loans, where banks can go after the borrowers for the remainder of the unpaid debt.

But it’s not just state-by-state. If you had a non-recourse first mortgage but you refinanced, your new loan is probably recourse. If you have a second loan or home equity line, those loans are probably recourse. Mortgages on investment property and vacation homes are most likely recourse.

I strongly encourage anyone who isn’t 100% sure of their rights to bring a copy of their mortgage note to a qualified attorney.

If a consumer is liable for the debt, the bank will file a deficiency judgement at some point to try and collect. Or, the bank will sell that debt to a “distressed debt” investor who will do the same thing. This type of debt typically sells for between 2 and 7 cents-on-the-dollar.

Consider “We are waiting for the economy to somewhat heal so that it’s a better time to go after people”

Countless foreclosure victims will be hit with deficiency judgments for the unpaid portions of their foreclosed mortgages in the coming years. Most states allow lenders to sue borrowers for an unpaid balance, some for as long as 20 years. Many of the collection agencies and distressed-debt investors have not bothered trying to collect yet, because they know that most people don’t have much money. But as soon as the economy begins to turn, expect the flurry of deficiency judgments to begin.

…

Silverleaf Advisors LLC, a Miami private-equity firm, is one investor in battered mortgage debt. Instead of buying ready-made deficiency judgments, it buys banks’ soured mortgages and goes to court itself to get judgments for debt that remains after foreclosure sales.

Silverleaf says its collection efforts are limited. “We are waiting for the economy to somewhat heal so that it’s a better time to go after people,” says Douglas Hannah, managing director of Silverleaf.

Investors know that most states allow up to 20 years to try to collect the debts, ample time for the borrowers to get back on their feet. Meanwhile, the debts grow at about an 8% interest rate, depending on the state.

This point is one of the key benefits of doing a short sale, versus a foreclosure. With a foreclosure, a consumer has no power and no way to protect themselves from a deficiency judgement. However, in a short sale, they have leverage to negotiate with the bank, asking them to agree to forgive and extinguish the outstanding debt.

The Foreclosure Sale

California is a “non-judicial” foreclosure state, meaning the bank can complete the foreclosure without court involvement. Even though the “sale” typically takes place on the courthouse steps, the courthouse isn’t actually involved. This is done from custom – note that the activity is outside the courthouse, not in it.

At the “sale” (or “auction”), the property will be “sold,” either to a 3rd party (an investor) or back to the bank. If the property is sold back to the bank, it becomes a “bank-owned” property.

The actual process is fast-moving. To best show you what happens, please watch this video from my friend Sean O’Toole of ForeclosureRadar. Their service is primarily for real estate investors, so the video is narrated from that perspective.

NOTE: This page is meant to be educational for regular homeowners, buyers, and sellers. I will be putting together an investment guide for professionals down the road.

Cash-For-Keys or Eviction

Once the foreclosure “sale” is official, the home now either belongs to the bank, or to a 3rd party investor. I’ll explain the next steps that banks generally take, understanding that independent investors will still basically do through the same processes.

The first step is to see if the property is vacant. Within a day or two of the sale, the bank will assign the property to one of the local real estate agents that they work with. That agent’s first task will be to determine if anyone is living there and if they are a renter or the former owner.

States are passing laws to protect renters, trying to give them the right to stay in the home to the end of their lease. And, as long as there actually is a lease in place (not month-to-month) and the renters aren’t in any way related to the former owners, they may be able to stay.

The agent will assess the situation and report back to the bank. The bank will then authorize the agent to offer the occupants cash-for-keys. There would be an agreed-upon move-out date (usually 2-3 weeks out), and the occupant is required to completely move out and leave the property in “broom-swept” condition. On the move-out date, the agent inspects the house and then will literally give the occupants a check in return for the keys.

Two important points here. First, the dollar amount is negotiable. I would advise any occupant to ask for more – even double whatever the initial offer is. Second, the bank will start the eviction process. This friendly arrangement is a one-time deal. If the occupant doesn’t move out, they can expect the bank to move to evict them as quickly as possible – which will only make it that much harder for them to qualify for a rental.

Now, not every investor will offer the occupants cash-for-keys. But all occupants should ask for it. Moving, deposits, and first & last month’s rent is expensive and everyone knows it. Even if your home is sold to a 3rd party investor, you will likely be able to negotiate for some cash in return for you moving out quickly and nicely.

Preparing the Property for Market

Once the property is vacant, the bank and their agent take steps to prepare the home for resale. On average, this entire process usually takes 3-4 weeks from the time the home is vacant.

1. They will change the locks and take safety precautions for swimming pools.
2. They will change the utilities into either the bank or agent’s name and usually turn on the power and water.
3. The agent will do a Broker’s Price Opinion, or “BPO,” which is a down-and-dirty appraisal giving the value of the home in it’s current condition.
4. The bank will usually have another agent do a BPO as well (and pay them $50-$75).
5. The bank will decide to sell the home in it’s current condition, or to make some basic repairs first.
6. Finally, the bank will pick a list price and send over a type of listing contract to their agent. The agent usually has 24 hours to get the property entered into the MLS and up for sale.

There are a couple of other things to understand about this process. First, the person representing the bank is called an “asset manager.” They are the ones who directly communicate with the local agent. Behind the asset manager is the “investor,” which is typically one individual who makes the decisions on behalf of whoever or whatever actually owns the note.

Also, people often ask if they can submit an offer to the bank during this stretch. The answer, generally, is no. Up until the very last minute, the bank doesn’t even know what the home is worth. And, the listing agent will only know the list price a few hours before they have to publicize it in the MLS.

Reselling the Property

Foreclosures sell in much the same way as traditional sales or short sales. There are, however, some additional considerations.

The Listing Agents

• They are typically really busy
• Don’t take it personally if they don’t call you or your agent back quickly
• They don’t make much money off of any individual sale

More Addendums, Fewer Disclosures

• After the bank agrees to the terms in your normal purchase contract, they will send you their own lengthy contract as an addendum that supercedes the original contract. Read it.
• The bank will not disclose much about the house because it doesn’t know anything about the house. Understand that you could be buying a home where someone has died or that has other not-obvious problems. It is worth meeting the neighbors during your contingency period.

• The bank will insist that this is an “as-is” deal, meaning that you as a buyer agree that the bank will not make any repairs.
• However, buyers will still almost always have a contingency period, where they can chose to back out of the deal if they find things they don’t like.
• And, of course, before backing out, buyers will ask the bank to either fix the problem or credit them money so they can fix it. The bank will negotiate or make repairs just like any other seller.
• Thus, as long as there is an inspection contingency, no deal is really “as-is”

Lending Considerations

• If the property is in good shape, buyers should be able to finance it just as they would any other purchase
• However, foreclosures sometimes aren’t in great shape, and it’s possible that the property may not qualify for FHA or even traditional Fannie/Freddie financing. Ask your agent. Ask your mortgage broker.

Getting a Discount

• Bank-owned homes don’t necessarily sell for a discount. Statistics might suggest so, but that’s because more of them are in poor condition.
• Don’t expect to buy the home for too much less than the list price, especially if the home has only been listed at that price for a few weeks. The bank listed the home at that price because it thinks it can get it.
• Banks will drop their prices more frequently and drastically than traditional sellers. It’s business, and they will do what it takes to sell the home.
• A bank will accept a cash offer that is slightly lower than an offer with financing. They know that escrows with financing fall apart more frequently.

A Final Note: Life After Foreclosure

While the process is painful, there is life after foreclosure. For many, the hardest part is actually making the decision to let go. The “letting go” is pretty easy by comparison and the process is often liberating. Once the house and the debt are gone, the healing can begin.

Reasonable estimates are that 1 in 5 homes with a mortgage will go through foreclosure in the coming years. That’s a big number. If you think you are at risk of foreclosure, you aren’t alone. If you are hoping to purchase a foreclosure in the coming years, you’ll have plenty of chances.

Even if you aren’t at risk and you don’t plan to move, foreclosures will continue to be one of the most dominant issues in our culture and our economy for many years to come.