When I started real estate investing, I learned about buying homes at foreclosure auctions more or less right out of the gate. Purchasing property at an auction makes sense intuitively, and learning about which details should be paid attention to with foreclosed properties (like being responsible for unpaid taxes and liens) was great practice for all the business I’ve done since then. A couple of years later, I learned about preforeclosures, and that’s where things really started to take off.
Preforeclosures are excellent opportunities for investors willing to deal with homeowners instead of county officials like you would at a foreclosure auction. But, they’re a different beast, especially regarding your financing options and the stakeholders whose consent you’ll need to win to clinch the deal. In my experience, newer real estate investors tend to shy away from preforeclosures because of those differences, and I think it’s to their detriment.
You don’t need to be an expert on every aspect of the preforeclosure purchasing process today. You should, however, become confident in one of the essential parts of the process: preforeclosure financing. Once you understand the ins and outs of how to finance your purchases, you’ll be better equipped to engage with the most difficult parts of preforeclosure investing, like negotiating diplomatically and kindly when talking to homeowners. If you’re not sure exactly what I mean by that or what the preforeclosure process even is, don’t worry, we’re about to go over it piece by piece. It’ll still be up to you to practice what you learn, of course.
How Preforeclosures Homes Are Different From Foreclosures
Before you get into investing in preforeclosures, you should have a strong understanding of what a preforeclosure actually is.
With a foreclosed property, lenders have already found the owners who default on their debt obligations. To recoup their investment, the lenders initiate a foreclosure, which causes the home occupants to be evicted. Then, the foreclosed home goes to auction, which is typically facilitated by county-level authorities in the government. The auction proceeds are then passed back to the lender, and the ownership of the home is transferred to the buyer.
In a preforeclosure, the process is different.
Because foreclosures are paperwork-intensive for lenders, they don’t foreclose on debtors who are in default immediately after they miss a mortgage payment. Instead, homes enter a state of preforeclosure when the homeowner is issued a notice of default. That often takes as long as two months after the original date of default, but the debtors will still be liable for everything they owe, not just the outstanding payments at the time of the letter.
Once the notice of default is issued, the homeowner has up to six months to settle their outstanding balance with the lender or risk foreclosure. A preforeclosure sale of the home is one way to avoid foreclosure, though many people try to remedy their finances in other ways such that they don’t need to leave their home. Even if there’s no way to address the outstanding balance on the mortgage, a preforeclosure sale can still be beneficial for the owner, as it may allow them to retain some of their equity even if the lion’s portion of it is underwater.
The critical thing to remember is that buyers will communicate directly with the homeowner to make offers. At the same time, the lender won’t be interested in abiding by the terms you offer to the homeowner to avoid foreclosure unless they’re sufficient to bring the property back into good standing. Suppose you see a preforeclosure on an MLS or other publicly-available source of leads. In that case, there’s a pretty high chance that the homeowner has acknowledged that their financial issues can’t be solved without selling their property.
So, you should think of successful preforeclosure transactions as solving the underwater liabilities of the homeowner and their lender at the same time. You’ll also need to find a way to make a profit on the property by investing in it after the purchase, as you might not gain much through the transaction itself for reasons I’ll get into later.
When Can Preforeclosure Sales Happen?
There are a few essential requirements for preforeclosure sales, and you’ll need to get an appraisal of the house in question to see if they are fulfilled, so that should be your first step.
After that, you’ll need to verify that the property is worth at least 70% of the mortgage balance in default. If the home is too dilapidated, lenders may prefer to take their chances at auction rather than settle for a short sale via you and the homeowner.
The following requirement is that the ultimate sale price of the property must be within 5% of its appraised worth. Lenders aren’t interested in taking a bigger haircut on the property than they would be risking via the foreclosure process.
In terms of the significant differences with foreclosure homes in your workflow as an investor, preforeclosures:
- Involve outreach to and negotiating with homeowners as well as lenders
- They are harder to find as leads
- Can move deals from inception to completion a bit slower
But, you should plan to do just as much due diligence with preforeclosures as you would with foreclosed properties. And, your financing options may be somewhat more constrained, so it’s essential to have your ducks in a row before moving forward.
Getting preforeclosure financing can be a bit more complicated than getting funding for purchasing a primary residence, foreclosures, or for a standard fix-and-flip opportunity.
In the case of a preforeclosure, the mortgage needs to cover the balance that the current homeowner owes to their lender, and any unpaid taxes, insurance policies, and liens. You’ll also be on the hook for the remainder of the principal left unpaid by the seller.
Even before evaluating your options, calculating how much money you’ll actually need for your preforeclosure financing is a critical part of the process. You’ll probably want to spend a lot of time compiling your due diligence on the property, and get a house inspection just to make sure that you didn’t miss any major structural issues.
And, while it isn’t something you’ll always need to find money for in the financing process, preforeclosures tend to be a bit behind on their maintenance. Therefore, if you’re planning on selling the preforeclosure in the future, you should plan for repair costs too, even if you don’t need to borrow any additional money at the time of purchasing.
Once you’ve attended to those details, you can start evaluating which preforeclosure financing avenues will be the best fit for your business. Let’s take a look at a trio of the possibilities so that you’ll have a better understanding of where to start.
Standard Mortgages and Loans
Public financing options like Federal Housing Authority (FHA) loans might seem appealing to some investors, as FHA loans enable purchasing of homes with as little as 3.5% of the selling price paid up-front in the down payment.
While it might technically be possible to buy a preforeclosure using an FHA loan, in practice, it isn’t a preforeclosure financing tool that real estate investors use.
This is because FHA loans are only disbursable for purchases of properties that are intended to be the buyer’s primary residence. So, if you happen to be in the market for a new primary residence that happens to be a preforeclosure, it could still be an option, but you’ll need to look elsewhere for financing to scale your business.
Besides, you’re obligated to pay for mortgage insurance with FHA loans if you don’t reach a certain threshold with the down payment. That expense means that you’ll be building less equity and burning more cash, both of which are less than ideal.
Hard Money Loans
Hard money loans are the go-to choice for real estate investors seeking preforeclosure financing. With a hard money loan, lenders hold the house’s equity as collateral in exchange for the cash it takes to close the deal. Then, you’ll be obligated to pay off the loan generally within a year—with plenty of interest to make it worth the lender’s while, of course.
Hard money loans are ideal for preforeclosure financing because they don’t require excellent credit to take out. Nor do they require dealing with traditional financial institutions, so it’s often possible to secure hard money financing much more rapidly. Furthermore, hard money lenders are typically individuals or private businesses, making them much more flexible and able to adapt to your needs.
The wrinkle with hard money loans for buying preforeclosures is that you’ll need to borrow enough to cover the aforementioned costs that the homeowner left unpaid. That means your lender will almost certainly demand a higher interest rate, and perhaps a larger portion of the home’s equity. After all, the more issues there are with a property, the more likely it’ll be that the lender will fail to make their money back, even when accounting for the fact that they will have the right to sell the home if you default for some reason.
In some circumstances, hard money lenders may even require you to pony up a portion of your future financial gain from the deal as part of the terms of financing. If you aren’t selective when it comes to vetting and picking a hard money financier, you will face a much higher risk of losing money on a preforeclosure. And, many of these lenders are prone to striking deals that leave debtors—like you and other investors—with the short end of the stick. There aren’t consumer protection laws for hard money lenders like there are for mortgages, which makes the entire process much more important to get right on your end.
Once you find a trustworthy hard money lender that works at the pace you’ll need for preforeclosure financing, you won’t want to let them go.
The Preforeclosure Purchasing Process
Now that you’re up to speed on your financing options, let’s run through the steps you’ll need to take to buy a preforeclosure home, assuming that you’re using hard money.
In short, you’ll need to:
- Find preforeclosure or short sale leads
- Identify the most profitable opportunities
- Compassionately reach out to the homeowner and see if they’re interested in making a short sale
- Confirm with the homeowner’s mortgage lender that a short sale is permissible
- Perform due diligence on the property and get it inspected
- Figure out how to monetize the property via fixing and flipping, renting, or another method
- Calculate how much money you’ll need to monetize the home, pay off its outstanding liabilities, and buy or control its outstanding equity
- Get pre-approved for the sum you calculated with your hard money lender
- Put an offer in with the homeowner and their lender
- Tap your hard money financing to pay the homeowner and their lender to close the deal
Purchasing the house is only part of the workflow, however. What happens in the aftermath of the purchase is where your investment return lies.
Once you take out hard money financing, you’ll need to start paying it off relatively soon. If you don’t, your lender will start the process of seizing your equity in the home as collateral. To make sure that doesn’t happen, you need to have a monetization plan in place and be ready to execute before getting the financing. And that’s still true whether you’re dealing with a preforeclosure or any other type of property, so it’s important to build good habits into the operation of your business.
Getting Connected to Lenders Doesn’t Have to Be Hard
Especially when you’re just starting out as an investor in preforeclosures, it pays to have a powerful ally in your corner when it comes to finding the right type of lenders. In this vein, many investors find that being an independently owned and operated HomeVestors® franchisee solves multiple issues in their businesses all at once. HomeVestors franchisees get intensive investment training, mentorship, access to valuation software, and even direct access to a hard money financing portal for financing qualifying purchases and repairs.
With HomeVestors, you won’t need to worry about seedy lenders taking advantage of you while you’re running down the clock on a preforeclosure short sale. Instead, the HomeVestors® financing portal will connect you with reputable, speedy, and approachable hard money lenders that have been pre-vetted by other investors just like you.
HomeVestors can also help you find preforeclosure properties on the market. Thanks to the nationally recognized We Buy Ugly Houses® marketing campaign, HomeVestors franchisees have an inbound marketing funnel for quality leads including preforeclosure prospects and more. When it comes to launching and scaling your business stridently, it’s hard to find a better opportunity than HomeVestors.
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