How Foreclosure Affects Homeowners and Lenders
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When you purchase a home with a mortgage loan, you sign papers agreeing to secure the loan with the property. A foreclosure happens if you miss too many payments and the lender decides to take back the property rather than wait for you to pay them the money they're owed. There are many types of foreclosures, but this article will focus mainly on the ones initiated by lenders and explain why they occur. We’ll also discuss how the foreclosure process works and what homeowners can do to prevent it.
Written by Attorney Curtis Lee.
Updated December 31, 2021
A foreclosure occurs when a borrower defaults on their mortgage loan. Then the lender steps in to take back the home because it served as collateral for the loan. This is a very stressful event for homeowners. Foreclosure can also be initiated by a homeowners’ association (HOA) when a member is behind on their HOA fees or by the IRS or local tax department when the property owner is behind on their taxes.
Most often, a bank, mortgage company, or other lender is the party that forecloses on a home. This article will focus on these types of foreclosures and explain why they occur. We’ll also discuss how the foreclosure process works and what homeowners can do to prevent it.
Why Do Lenders Foreclose?
All foreclosures begin because the borrower missed some type of payment. Usually, they’ve missed multiple mortgage payments.
A mortgage loan is a type of secured debt. Under the terms of the mortgage, the homebuyer agrees to have the home serve as collateral for the loan. This means that if the homeowner fails to make their mortgage payments and defaults on the loan, the mortgage lender has the legal right to take back the home through the process of foreclosure. In other words, lenders foreclose because they want the money back that they loaned to a homebuyer.
When the borrower purchases the home, they’ll sign documents at the closing that gives the lender these rights. A lien also gets placed on the title of the home. This shows any potential creditors or buyers that the property is subject to a mortgage. When the homeowner pays off the mortgage, this lien is removed.
A home “in foreclosure” is currently going through the foreclosure process. In contrast, a “foreclosed home” or a real estate-owned (REO) property has gone through a foreclosure proceeding. It’s also a property that is currently owned solely by the lender, bank, or mortgage company.
What Causes Homeowners To Go Into Foreclosure?
Often, one or more unanticipated events lead to foreclosure. At first, homebuyers can usually afford their monthly mortgage payments. During the process of getting approved for a home loan, lenders require future homebuyers to provide a lot of financial information. This includes their income, prior existing debts, and credit history. The lender will verify this information and compare it to financial metrics like a borrower’s debt-to-income ratio. They then decide whether to grant the loan or not.
Despite these precautions and the best of intentions, things don’t always go as expected. Unforeseen circumstances can occur that can have a negative impact on the borrowers’ ability to pay their mortgage, such as:
Increased debt after buying the home
A significant medical issue
A large, unexpected expense
Loss or reduction of income because of a divorce or death in the family
An increase in living expenses
Borrowers relocating before selling their first home, which takes longer to sell than anticipated
A higher mortgage payment due to rising property taxes, insurance premiums, and/or higher interest rates on adjustable-rate mortgages
The property value decreases and puts the mortgage “underwater”
An underwater mortgage means the home’s fair market value is less than what the homeowner owes on the mortgage. This lack of equity means that some homeowners have no incentive to continue making mortgage payments. So if it makes financial sense to do so under the terms of their mortgage, some homeowners will walk away from the home, leaving the property to the lender.
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How Does the Foreclosure Process Work?
There are two basic types of foreclosures. The first is a judicial foreclosure. This involves a court and allows the homeowner to legally challenge the foreclosure. Every state allows for judicial foreclosures. The second is a nonjudicial foreclosure, which is a foreclosure where the lender doesn’t need to go to court. This is why nonjudicial foreclosures are faster and easier for lenders. They also give homeowners less time to contest the foreclosure.
Not all states allow nonjudicial foreclosures, and the ones that do may have their own procedures for the process. Whether it’s a judicial or nonjudicial foreclosure, most foreclosures involve the following five steps.
A foreclosure can’t occur unless the homeowner defaults. For most home foreclosures, federal law requires the loan servicer to wait until the borrower hasn’t made a payment for 120 days. Only then can they start the foreclosure legal process. Your mortgage terms will outline what else a default means for your particular loan.
The foreclosure can begin regardless of why the homeowner fails to make the mortgage payments. Once the homeowner misses the required number of payments, the lender can start the foreclosure process with a public notice.
This is step two of the foreclosure process. The lender gives public and written notice to the borrower stating that the lender will pursue legal action if the debt isn’t paid. This may be the borrower’s first official notice that they must become current on their mortgage or lose their home in a foreclosure.
The public notice can take one of two forms, either of which will begin the pre-foreclosure process. If going through a nonjudicial foreclosure, the lender will typically send the borrower a notice of default. If there’s a judicial foreclosure, the lender will file a lawsuit in court, which includes a legal notice called a lis pendens. A lis pendens notifies the borrower that the lender has filed a lawsuit against them to foreclose on the home.
After the public notice gets recorded, it’s time for step three in the foreclosure process. The homeowner often has just 90 days to take action to try to contest the foreclosure. To avoid foreclosure, homeowners can try one of the following strategies.
Cure the default.
First, the homeowner can pay any outstanding mortgage balance and applicable fees to reverse the default. This is called curing the default, but it isn’t a realistic option for most borrowers. If they had enough money to cure the default, they never would have found themselves in foreclosure to begin with.
Sell the home.
Second, if there’s enough equity in the home, the borrower can sell the home and pay off the loan. Keep in mind that the sale price will need to be more than the amount the borrower still owes on the mortgage loan. There will also be costs associated with the sale and possibly fees and penalties to pay.
Do a short sale.
Third, if the mortgage is underwater or the borrower doesn’t have sufficient equity to fully pay off the loan, the homeowner can sell the property in a short sale. These are called short sales because the selling price will fall short of the money needed to pay off the loan. All short sale proceeds go to the lender, and the lender must agree to the sale first. Even though a short sale isn’t enough to fully pay what the borrower owes, a lender and homeowner might want to pursue a short sale because:
It can be less damaging to the homeowner’s credit and ability to get a future mortgage.
It saves the lender time and money by avoiding the rest of the foreclosure process. Even though short sales don’t fully shore up the loan, the lender might still recover more money than they would if they foreclosed on the home. This is especially true if the homeowner is prepared to fight the foreclosure in court.
It’s possible for a short sale to result in a higher-than-expected selling price. If this results in enough money to pay off the loan balance with money leftover, the homeowner can keep the extra money.
Consider a deed in lieu of foreclosure.
Fourth, the homeowner can sign the deed to their home over to the lender through a deed in lieu of foreclosure. In this process, the homeowner voluntarily signs the home’s deed over to the lender. In return, the lender agrees to release the homeowner from all mortgage obligations. This release can include any liability to pay a deficiency balance.
A deed in lieu of foreclosure is great for the homeowner because it’s far less damaging to their credit score than having their home foreclosed. This makes it easier to get a mortgage in the future. Lenders may agree to this arrangement because it’s cheaper and faster than the foreclosure process. But a lender has no obligation to accept a deed in lieu of foreclosure offer.
If none of the above actions work to prevent foreclosure, the property will go to a public auction or foreclosure sale.
Public auction and foreclosure sale processes vary by state and locality. In addition to state and local laws, the preferences of the lender and the terms of the mortgage loan will control what happens. But most public foreclosure auctions have similar requirements and procedures. To start, these sales are open to the public. They may take place on the steps of a county courthouse, in a conference room, at a convention center, or online. A notice of trustee sale will inform the homeowner and general public of the auction's date, time, location, and other details.
The foreclosed home gets sold to the highest bidder, although many foreclosure auction sales will have a minimum bid set at the balance owed on the loan. After winning the foreclosed home, the winning bidder must immediately pay for the purchase or put down a significant cash deposit.
In some states, after the foreclosure sale is complete, the previous homeowner will have one last chance to keep their home. This “right of redemption” allows a homeowner to buy back the home after the auction. Typically, they must pay the auction sale price or full loan balance plus any additional interest or costs incurred by the lender during the foreclosure process. The amount of time a homeowner has to take advantage of the right of redemption depends on state law. In some states, the homeowner has until the clerk of court files the certificate of sale. In other states, the homeowner might have up to one year after the auction sale.
This is the fifth and final step of the foreclosure process. After the property gets sold at auction, the previous homeowner must leave. The exact amount of time they have to move out can vary. If they aren’t willing to move out, the new owner can begin a formal eviction process. After taking possession of the property, the new owner can handle the property however they like.
Many times, the property isn’t successfully sold at auction and becomes an REO. This often occurs because the lender or real estate company that owns the property doesn’t get the price they want or need during the public auction. As the sole owner of the property, the lender or real estate company is now responsible for paying property taxes on the home and maintaining it. So if the property becomes an REO, the owner will work hard to get rid of the property as soon as possible.
Avoiding Foreclosure Before It Happens
Facing foreclosure can be challenging, both financially and psychologically. But many homeowners don’t realize that most lenders also really want to avoid foreclosure. When a homeowner can’t make their mortgage payments, the lender loses out on the money they’d normally receive each month. On top of that, they take on the legal and/or administrative costs of foreclosure. If the home doesn’t sell at auction, the lender is stuck with the property and is responsible for any taxes and maintenance costs.
As a result, lenders are often willing to work with homeowners to modify or restructure their loans to help prevent foreclosure. Lenders may offer one or more of the following:
Repayment plans: These allow homeowners to make up missed payments over time. The homeowner will make their regular mortgage payments in addition to the makeup payments.
Forbearance agreements: A lender allows the borrower to make reduced or no mortgage payments for a period of time, often three to six months. When the forbearance period ends, the borrower makes up the missed payments with a repayment plan or in a lump sum. Alternatively, the lender may agree to tack on the missed payments to the back of the loan and extend its term.
Home loan modifications: These areagreements between lenders and borrowers to adjust an existing loan’s terms. Modifications usually include lowering the interest rate, extending the loan’s term, and/or adding any missed payments to the loan’s balance.
Additional assistance options for homeowners include:
Foreclosure mediation: Here, the lender and homeowner meet with an impartial third party (the mediator) to discuss ways to avoid foreclosure. Foreclosure mediation is only available in some states, and its availability varies even among counties or municipalities.
HUD-certified financial counseling: The U.S. Department of Housing and Urban Development (HUD) sponsors numerous counseling agencies throughout the United States that help homeowners with financial issues, including foreclosure.
Government mortgage relief programs: Programs differ but can involve helping borrowers get into more stable loans with lower monthly payments and interest rates. One of the most prominent is the Making Home Affordable Program.
A mortgage loan is a type of secured debt. It allows a lender to take back property serving as collateral if a borrower fails to keep up with their loan payments. Most home foreclosures are the result of homeowners missing multiple payments causing a default. Foreclosures can occur with or without court action. Regardless of the foreclosure process used, they’ll consist of the following five steps: missed payments, public notice, homeowner’s opportunity to stop foreclosure, the foreclosure auction, and post-foreclosure where the homeowners must leave the property.
Lenders often have one or more tools in place to help homeowners who are at risk of foreclosure. There are also many government-based programs, counseling, and mediation resources available for homeowners facing foreclosure.