The housing market is hot, with average home prices rising more than 20% in the past year. Rising prices are good news for sellers but can leave buyers scrambling to find a home they can afford. Pre-foreclosed homes usually sell for less than the full market value, making them an attractive option for bargain hunters and investors. However, buying a pre-foreclosed home comes with risks.

What Is a Pre-Foreclosed Home?

When homeowners cannot make their mortgage payments, lenders may choose to repossess the home and sell it to recover a portion of the unpaid mortgage. Lenders refer to this process as a foreclosure. Pre-foreclosure is the first step in the foreclosure process.

Pre-foreclosure gives homeowners a chance to get caught up on their mortgage payments or make a payment arrangement before the lender forecloses on the home. A house goes into pre-foreclosure when the lender issues a notice of default.

How Does the Pre-Foreclosure Process Work?

Most lenders issue a notice of default after homeowners have failed to make three consecutive payments. However, lender policies may vary depending on state regulations and the internal policies of each lender. Additionally, some lenders will work with borrowers who contact them to make payment arrangements.

Once the lender decides to issue the notice of default, the lender sends a written notification to the borrower and the County Recorder's office that the lender may pursue legal action if the debt remains unpaid. This officially begins the pre-foreclosure process.

The homeowner then typically has between three and 10 months to make payment arrangements with the lender before the lender sells the home. However, this time frame may vary by state and by the lender.

How Many Homes Are in Pre-Foreclosure?

Foreclosure rates fluctuate with market conditions. Lenders began the foreclosure process on 50,759 properties in the United States in the first quarter of 2022. This represents a 67% increase over the previous quarter. However, these numbers may reflect a backlog caused by the foreclosure moratorium the federal government put in place in 2020.

Industry analysts expect foreclosure starts to continue to rise through the end of 2022 before leveling off to historical averages. However, these projections may change if the economy gets significantly better or worse.

How Can You Find Out Which Homes Are in Pre-Foreclosure?

The notice of default that lenders send to homeowners is a public record. You can identify homes in pre-foreclosure by going to the county courthouse and looking through the records. However, this method is cumbersome and time-consuming. Most people interested in buying pre-foreclosed homes use another method:

• Purchase leads online

• Search online directories

• Read the public notices in the local paper

• Find out from their network

• Work with a real estate agent or attorney

Subscription-based services where buyers pay companies to send them a list of pre-foreclosure homes are the most popular option because it doesn't require searching through any records.

Who Can Purchase a Pre-Foreclosed Home?

Most buyers of pre-foreclosed homes are real estate investors; however, anyone can purchase a pre-foreclosed home. If you are considering buying a pre-foreclosed home, it is important to research the process and consider the benefits and risks.

Risks of Buying a Pre-Foreclosed Home

There are three main risks buyers of pre-foreclosed homes face:

1. Unpaid Taxes and Liens

People who are struggling to pay their mortgage may also not have the money to pay their taxes or have liens placed against the property for other unpaid debts. If you purchase a pre-foreclosed home that has unpaid taxes or liens, you must pay them. Some sellers may not disclose this information when you are negotiating with them. Avoid this potential problem by doing a title search before you make an offer.

2. Expensive Repairs

If a homeowner has no money to pay the mortgage, they probably also do not have the money to make needed repairs to the property. Additionally, some homeowners decide to stop maintaining their property when they find out the bank is going to foreclose.

Pre-foreclosure homes may be in poor condition and require expensive repairs to get them in livable or resaleable condition. Inspect the home and get an estimate for any repairs you may need to make. To be safe, assume that repairs may cost more than the estimate and make your offer accordingly.

3. Inexperience

Buying a pre-foreclosure home is higher risk and more complex than buying a regular property. Investors have the luxury of learning the ins and outs of the process as they gain experience purchasing pre-foreclosure homes.

Bargain hunters are probably only going to go through this process once or twice. Before you consider buying a pre-foreclosure home, it is a good idea to research and make sure you completely understand how the pre-foreclosure and foreclosure process works and how to identify a pre-foreclosure home that is a good buy.

Benefits of Buying a Pre-Foreclosed Home

While buying a pre-foreclosed home comes with risks, those risks may be worthwhile for the potential benefits:

1. Lower Price

Lower sales prices are the main reason people seek out pre-foreclosure homes. The higher risks and need to sell the property quickly may motivate sellers to price pre-foreclosure homes at 20 to 50% below the market value.

2. Reduced Purchasing Expenses

Because homeowners facing foreclosure have the motivation to sell quickly, you may be able to negotiate lower closing costs, smaller down payments and better financing options than with a traditional sale. In some cases, you may be able to pay off what the seller owes in cash and avoid financing costs completely.

3. Rehab Potential

If you can make repairs yourself or know someone who can make repairs inexpensively, you may be able to dramatically increase the value of some pre-foreclosure properties without spending a lot of money. This makes pre-foreclosures an attractive option for flippers and bargain hunters who are also do-it-yourself enthusiasts.

4. Quick Move-In

Most homes in pre-foreclosure are either already vacant or the seller knows they are going to have to move out soon. This often means that you can move into or start renovating the home shortly after you purchase it.

Can You Finance a Pre-Foreclosed Home?

You can finance a pre-foreclosed home, and you may even be able to work out a favorable financing agreement with the lender that holds the current mortgage. However, many investors pay cash and sellers tend to prefer cash offers, so if you have to finance, you may miss out on the home you want.

How Do You Buy a Pre-Foreclosure Home?

Purchasing a pre-foreclosure home is a multi-step process:

1. Identify Pre-Foreclosure Properties You May Want To Buy

Use the methods above to identify pre-foreclosure homes you may want to buy. If possible, travel to the location to look at the home. The homeowner may still be living there, so be respectful.

2. Verify the Home Is Still In Pre-Foreclosure

Not every homeowner with a home in pre-foreclosure will want to sell. Some will make a deal with the lender to get the home out of foreclosure. Before you proceed, check with the trustee who filed the foreclosure paperwork to find out if the home is still in pre-foreclosure.

3. Research the Value

Search public records to find out how much money the homeowner owes on the home and whether there are any liens or unpaid taxes. Use online tools or talk to a local real estate agent about the market value of the home and what the home is likely to sell for if the lender forecloses.

4. Calculate Your Breakeven Point

Estimate the total costs of purchasing the property, including any outstanding loan balance, liens and insurance. Subtract this total from the estimated market value of the property. This figure represents the amount you can pay the seller without either gaining or losing money on the purchase.

5. Contact the Homeowner

Call the homeowner or send them a letter to express your interest in purchasing the property. Keep in mind that the homeowner may not want to sell and may be under significant financial stress. Be professional and polite. If the homeowner is open to selling, arrange a time when you can inspect the property and talk about a potential sale.

6. Adjust Your Breakeven Estimate

Inspect the property and estimate the repair costs. If you are not an expert on home repairs, take a contractor with you. Subtract the estimated cost of repairs from your previous breakeven estimate.

7. Negotiate With the Seller

Many factors determine what a good offer on a pre-foreclosed property is. If you lack experience, you may want to talk to a real estate agent, investor or lawyer with experience working with pre-foreclosed homes before you make an offer. A good rule of thumb is to set a goal of negotiating a purchase price that is at least 20% below your breakeven point.

8. Draft a Purchase Agreement

When you agree to a sales price with the homeowner, draft a purchase agreement that is contingent on a professional inspection of the property and a full title search. Unless you are a legal expert, get a real estate agent or an attorney to help you with this. Work with an escrow company to handle the transfer of the property ownership and money.

Whether you want to get into real estate investment or find a good deal on your dream home, pre-foreclosure properties can be an excellent investment. However, it is important to do your research and be aware of the potential risks before you make an offer.