Foreclosure Explained: How and Why It Happens
Foreclosure is the process lenders use to take property from borrowers. By taking legal action against a borrower who has stopped making payments, lenders try to get their money back. For example, they take ownership of your house, sell it, and use the sales proceeds to pay off your home loan.
How Foreclosure Works
When you buy expensive property, such as a home, you might not have enough money to pay the entire purchase price up front. However, you can pay a portion of the price with a down payment, and borrow the rest of the money (to be repaid in future years).
Homes can cost hundreds of thousands of dollars, and most people don’t earn anywhere near that much annually. Why are lenders willing to offer such large loans? As part of the loan agreement, you agree that the property you’re buying will serve as collateral for the loan: if you stop making payments, the lender can take possession of the property in order to recover the funds they lent you.
Consequences of Foreclosure
The main problem with going through foreclosure is, of course, the fact that you will be forced out of your home. You’ll need to find another place to live, and the process is stressful (among other things) for you and your family.
Foreclosure can also be expensive. As you stop making payments, your lender will charge penalties and legal fees, and you might pay legal fees out of pocket to fight foreclosure. Any fees added to your account will increase your debt to the lender, and you might still owe money after your home is taken and sold if the sales proceeds are not sufficient (known as a deficiency).
Foreclosure will also hurt your credit scores. Your credit reports will show the foreclosure, which credit scoring models will see as a negative signal. You’ll have a hard time borrowing to buy another home for several years (although you might be able to get certain government loans within one to two years), and you’ll also have more difficulty getting affordable loans of any kind. Your credit scores can also affect other areas of your life, such as (in limited cases) your ability to get a job or your insurance rates.
How to Avoid Foreclosure
Foreclosure is a last resort for lenders who have given up hope of being paid. The process is time-consuming and expensive for them (but they can try to charge those fees to you), and it is extremely unpleasant for borrowers. So how can you avoid it?
- Communication: it’s always a good idea to communicate with your lender if you’re having financial challenges. Get in touch before you start missing payments and ask if anything can be done. If you start missing payments, don’t ignore communication from your lender – you’ll receive important notices telling you where you are in the process and what rights and options you still have. Speak with a local real estate attorney or HUD housing counselor to understand what’s going on.
- Explore alternatives to keep your home: if you know that you won’t be able to make your payments, find out what options are available to you – even if you think it’s too late. You might get help through government programs geared towards struggling borrowers. Your lender might offer some kind of loan modification, which would make your loan more affordable. You might even be able to work out a simple payment plan with your lender if you just need relief for a month or two (if you’re in between jobs, or for surprise medical expenses, for example).
- Alternative ways to leave your home: foreclosure is a long, unpleasant, expensive process that damages your credit. If you’re simply ready to move on (and you want to at least try to minimize the damage), see if your lender will agree to a short sale. This allows you to sell the house and use the proceeds to pay off your lender – even if the loan isn’t completely repaid. Your credit will still suffer, but not as bad as it would after foreclosure. If that doesn’t work, another less attractive option is a deed in lieu of foreclosure.
- Bankruptcy: filing for bankruptcy might or might not help if you’re facing foreclosure. The issues are complex, so speak with a local attorney to get accurate information that’s tailored to your situation and your state of residence.
- Scams: because you’re in a desperate situation, you’re a target for con artists. Be wary of any unsolicited offers to help you avoid foreclosure, and choose carefully who helps you. Start seeking help from HUD counseling agencies and other reputable local agencies. Know the signs of foreclosure rescue scams.
The Foreclosure Process
Foreclosure is generally a slow process. If you miss one or two payments, you’re probably not facing eviction. That’s why it’s important to communicate with your lender if you’ve fallen on hard times – it might not be too late. The details vary from lender to lender and laws are different in each state, so the description below is a rough overview and might not be exactly what you’ll experience – read all of your notices and agreements carefully and speak with an attorney or HUD housing counselor to make sure you know what’s happening. The entire process could take a year or two, or it could move much faster.
- Notices start: once you’ve missed payments for three months, many lenders consider your loan in default. This is when things get critical. You will, of course, receive communications as soon as you miss a payment (or two), and those communications might include a notice of intent to move forward with the foreclosure process.
- Judicial and nonjudicial states: depending on what state you’re in, you’ll have more time (and receive more notices) than others. There are two types of states – judicial states and nonjudicial states. In judicial states, your lender must bring legal action against you in the courts to foreclose. This process takes longer, as you often have 30 to 90 days in between each event. In nonjudicial states, lenders can foreclose based on the agreements you’ve signed with them, and a judge is not involved. As you might imagine, things move much faster in nonjudicial states. In either type of state, you can fight the foreclosure in court – in a judicial state you’ll generally be served with a summons, but in a nonjudicial state you’ll need to bring legal action against your lender to stop the foreclosure process. Speak with a local attorney for more details.
- Stopping the process: in most states, lenders are required to offer borrowers some kind of a relief to stop the foreclosure process. Whether or not those options are realistic or feasible is another matter. Lenders might say that you can reinstate and stay in the home if you make all (or a substantial portion) of your missed payments and cover the legal fees and penalties charged so far. You might also have an opportunity to pay off the loan in its entirety (which will only happen if you manage to refinance or find a huge source of money).
- Auction and eviction: if you’re unable to prevent foreclosure, the property is made available to the highest bidder at auction. If nobody else buys the home (which is common), ownership goes to the lender. At that point, if you’re still in the house (and haven't made arrangements to protect the house), you face the possibility of eviction and it’s time to line up new accommodations. Local laws dictate how long you can remain in the house after foreclosure, and you should receive a notice informing you how long you can stay. Ask your former lender about any “cash for keys” incentives, which can help ease the transition to new housing (assuming you’re ready to move quickly).