Updated May 17, 2019: Would-be buyers of foreclosures might feel intimidated by all their complexities. Don’t you have to pay all cash? Can’t you only get a mortgage from the bank that’s selling the house? Can you get financing at all if the place is run-down and in disrepair?
ICYMI, make sure to read our guide on shopping for a foreclosure.
Sheer confusion about financing can discourage people from exploring distressed properties if they don’t have boatloads of cash. In reality, many foreclosures and short sales are purchased with mortgages. You may even be able to finance the purchase and the cost of renovations under a single loan.
First, let’s clear one thing up.
Don’t you have to pay cash for a foreclosure?
No, not always. It depends on what stage of foreclosure the property is in: preforeclosure, auction or bank-owned. In the preforeclosure stage, the house can be sold through what’s called a short sale. The bank-owned stage is when the lender has taken possession of the property and is trying to sell it.
With short sales or bank-owned (also called real-estate-owned or REO) properties, you can finance the purchase with a mortgage. In fact, it’s common to do so. Wells Fargo says approximately 60% of its foreclosed homes are purchased with financing.
Getting a mortgage can sometimes be trickier with foreclosures. Short sales — when someone sells a house for less than is owed on the mortgage — can take a long time to complete. They require the mortgage lender to agree to accept less money than it is owed on the home loan. You might wait months for a bank to approve a short sale. Meanwhile, your interest rate lock could expire. Or the deal could fall through because the owner scrapes up the money they owe and stops the foreclosure process.
It is at foreclosure auctions that paying in cash is usually the rule.
“If a consumer wants to bid on a house that appraised at $400,000, they’ll have to bring cashier’s checks in increments of $100,000,” says Philip Boroda, director of REOs and foreclosures for Coldwell Banker in Los Angeles. Seasoned investors who purchase multiple properties might get different treatment. Boroda says he has noticed that investors who win a bid sometimes get extra time to bring in money.
The rules for auctions vary by state and county. For example, if you are the winning bidder for a $100,000 house in Lorain County, Ohio, you’d need to immediately hand over a cashier’s check for $5,000. You’d then have 30 days to bring a bank check for the remaining $95,000.
If you were to miss the deadline, interest would start to accrue on the balance at a relatively high rate of 10% a year. Worse, you could be held in contempt of court.
Fortunately, you only have to worry about these stringent rules for cash purchases with foreclosure auctions. For buyers who don’t have buckets of cash on hand, and are looking at bank-owned homes or short sales, here are six options for financing a foreclosed house.
1. Buying a bank-owned home with a conventional mortgage
Foreclosed homes are often in terrible condition. It can be difficult to get a mortgage for a house that has been left vacant, damaged by the previous owners, or robbed of copper plumbing by vandals. Banks typically won’t lend on a house with a hole in the roof or a missing furnace.
Homeowner’s insurance — a requirement for closing on a mortgage — can be costly for an REO property that’s in bad shape. Insurance companies charge higher premiums for the additional risk involved with homes that are older or in disrepair, and it’s common for that to be the case with foreclosed houses.
But REO properties that are basically livable, even if they need sprucing up, can be purchased using a conventional mortgage from a bank, credit union or mortgage lender. As with regular houses, lenders evaluate the borrower’s credit, income and ability to repay the loan according to underwriting standards set by government-backed mortgage giants Fannie Mae and Freddie Mac.
Loan amounts go up to $484,350 in 2019. Some expensive locales have higher allowances.
When financing the purchase of a foreclosure, it’s especially important to get preapproved for a mortgage early in the process. That way you’ll be better prepared to make a serious bid as soon as you find an attractive property, before it’s snapped up by cash-flush investors.
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Experts advise getting preapproved for a mortgage from the bank or lender selling the REO.
“They can’t force you to use their lender — it’s illegal. But they do trust their lender and don’t want to waste time with an unqualified buyer, so they want to run you through their internal system,” says Keith Watts, a real estate agent and short sale expert in Orange County, California.
You’re free to shop around with multiple mortgage lenders for the best pricing and terms, but it’s worth finding out the rate they’re offering.
“They might like it if you get the mortgage from them too, but they can’t insinuate that you’re not getting the deal if you don’t go through them,” Watts said.
2. Buying a foreclosure with a renovation loan
If a foreclosed home needs lots of rehab, you can finance it with a renovation mortgage that wraps the purchase price plus the construction cost into a single loan. One popular program is Fannie Mae’s HomeStyle renovation mortgage.
To qualify, you generally need a healthy credit score of at least 620. Borrowers with excellent credit and high income may be allowed to put down as little as 5% of the purchase price.
The funds can be used for any type of renovation, as long as it is permanently attached to the house and can be completed within 12 months. You’ll need to hire a licensed contractor to prepare a detailed construction budget. The renovation money doesn’t go to you directly. Instead, the funds go into an escrow account to be disbursed as needed.
Generally, you can get up to half the money immediately, so you can buy materials, pay architects or get permits. The rest of the money is deposited according to a predetermined construction schedule and paid out to the contractors when they complete work milestones. Once the work is complete, an appraiser must inspect everything.
3. Using an FHA loan to buy a bank-owned house
For people with less-than-perfect credit, Federal Housing Administration loans may be the best bet. Government-backed FHA loans are intended to help owner-occupants. They are not meant for investors or house-flippers. FHA loans can be used to buy almost any type of home, including bank-owned homes and short sales.
Thanks to federal backing, FHA-approved mortgage lenders are willing to provide more flexible underwriting and accept smaller down payments. The minimum credit score requirement is 500, for a mortgage with a down payment of 10%. With a score of 580 or higher, you may be able to put the minimum 3.5% down.
4. FHA 203(k) renovation loans
There are also two different FHA programs for financing renovations, called 203(k) renovation loans.
For smaller projects, the Limited 203(k) Mortgage allows you to add up to $35,000 to your mortgage to cover repairs and upgrades — for example, remodeling a kitchen, painting, or repairing minor problems uncovered by a home inspector.
The FHA 203(k) Rehab Mortgage covers a wide range of improvement projects, including structural repairs. There are hoops to jump through, such as a requirement to use an FHA-approved consultant.
As long as the property is at least one year old and the construction budget is at least $5,000, the funds can be used for big projects like roofing, plumbing and landscaping. They can even be used to rebuild a demolished house, as long as the original foundation is intact.
5. Home equity lines of credit for short-term financing
If you have equity in a home you own, you can open a home equity line of credit, which is sort of like a credit card that’s secured on your house. Lenders are typically willing to extend credit lines for up to 85% of home equity (defined as the market value of the home minus the amount owed on the mortgage). You only draw down the amount you need, and you only pay interest on the money you use.
It’s generally considered a bad financial move to use HELOC money for a down payment or as long-term financing for a foreclosure purchase. Interest rates on HELOCs are generally higher than on conventional 30-year mortgages (though lower than credit card interest rates). However, a HELOC can be a source of immediate cash for short-term projects, when you have a clear plan for repaying the funds quickly. Seasoned foreclosure investors may feel confident enough to use HELOC funds for purchases, but there is always the risk you could lose your home if anything goes awry.
6. Using hard money loans for real estate investments
Hard money loans are sometimes called “last resort loans.” These alternatives to bank loans are typically used by borrowers who aren’t eligible for a traditional mortgage or need speedy funds to buy and quickly flip properties.
Hard money loans are most suitable for sophisticated borrowers who are okay with risk and don’t mind paying higher fees and interest rates.
Good credit isn’t an issue with hard money loans. These non-bank lenders, usually private companies or investors, mainly evaluate the collateral rather than your personal financial history. They are concerned with whether the property securing the loan has a high enough value to protect them in case you default. You also have to have skin in the game. Down payment requirements can be as high as 30%.
Processing a hard money loan can be as quick as a couple of days. That speed can make a big difference when bidding on desirable foreclosures. Experienced investors sometimes buy a foreclosure with hard money, renovate it, then quickly refinance to a cheaper, conventional loan once the renovation is complete and the property can pass a bank inspection.
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Image: Tom Rumble