Financial institutions and lenders are not in the business of managing a portfolio of real estate property. For most, when a buyer (e.g. a real estate investor) that deals with a financial institution that owns real estate property, it can be a daunting experience. As a buyer, the process of purchasing a property may be a lengthy period. However, if the buyer can get through the extra work and the long waiting period, the purchase of the real estate property is usually worth the effort.
This article demonstrates the different types of foreclosures. This article is part of a series ‘All About Mortgages’ that answers questions for those who seek out general knowledge on the subject matter.
What is a Foreclosure?
When a borrower fails to meet the debt obligations that are required in a mortgage or deed of trust, the lender has the right to enforce the contract through foreclosure. A foreclosure is a legal process where the lender has the right to acquire possession of the property when the borrower defaults on their payments. It is where a property is pledged as security for a debt and it is sold to pay off that debt.
How Does the Foreclosure Process Work?
Both federal law and state law have their own process of foreclosure. It also depends on the type of property, location of the property, type of foreclosure, and type of loan. However, there are common principles of the foreclosure process.
First, for the lender to begin the process of foreclosure, the loan must be in default and a notice of default must be given to the borrower. A notice of default can begin as soon as the first payment is missed. The lender may send out the notice of default regardless of how many payments are missed.
Second, there may be a timeframe or redemption period where the borrower can bring the default payments to current status. There are several ways to bring the debt to current and ways to satisfy the lender, including, changing the terms of the loan, refinancing, or selling the property.
Third, the foreclosure process ends with the sale or public auction to satisfy the defaulted debt. However, in some states, there still is a redemption period for the borrower to buy back the property, e.g. three months to one year.
What is Nonjudicial Foreclosure?
Nonjudicial foreclosure is a type of foreclosure that does not use the court system, no court action is required. It is a foreclosure process, whereby, the lender causes the property to be sold to pay off the debt in case of default. Some states allow for a security instrument called a power-of-sale clause, which is a pre-authorization that the borrower signs in the contract. In states that recognize a deed of trust loan, the power-of-sale is given to the beneficiary.
When a financial institution enacts a nonjudicial foreclosure, the lender will send a notice of default to the borrower with the amount that must be paid to bring the debt to current, as well as the steps that will be taken if the debt does not become current. The next step will be a notice of foreclosure if the borrower does not bring the debt to current, this will also establish when the property will be sold at public auction. The notice of foreclosure will also be recorded to the public and specify the amount due as well as when the public auction date and time will be held. Once the property is sold during the public auction, the lender may be required to file a notice of affidavit.
What is Judicial Foreclosure?
Judicial foreclosure is the type of foreclosure that requires lenders to use the court system. This type of foreclosure is not frequently used. The process involves, where a lender must file a lawsuit after adequate public notice. In some cases, if the borrower defaults on payments, the lender may accelerate the due date of the remaining balance owed, including interest, late payments, administrative cost, and penalty fees.
What are the advantages and disadvantages of judicial foreclosure?
One big advantage that lenders have with a judicial foreclosure is that the lender may obtain a deficiency judgment. A deficiency judgment is an unsecured judgment against a borrower whose mortgage foreclosure did not meet the necessary funds to pay the loan in its entirety. The deficiency judgment makes the borrower personally liable if the property does not sell at the auction of the amount owed. As a borrower, if the lender uses this type of foreclosure, consult with a lawyer immediately to understand all the consequences. Each deficiency judgment is unique and different in each state.
The reason why a judicial foreclosure is rarely used is; a deficiency judgment usually is not collectible, since most borrowers who are not in default are able to keep their mortgages current. Also, the judgment could be discharged in bankruptcy. Further, a judicial foreclosure takes more time and it can get costly (e.g. Lawyer fees). There is also a longer redemptive period, where the borrower can also buy back the property after auction creating uncertainty for the lender.
Some states allow the lender to acquire property through strict foreclosure, which is a type of foreclosure that the court simply gives a title to the lender. First, the notice of default and notice of foreclosure must be sent out along with the time and date of the foreclosure. Once the property and foreclosure are recorded and the date that the debt must be paid in full, if the borrower does not pay in full by a certain date, the court simply gives a title to the lender.
Deed in Lieu of Foreclosure
In addition, as an alternative to a foreclosure, a lender may accept a deed in lieu of foreclosure. A deed in lieu of foreclosure in which the borrower transfers all interest of the property to the lender to satisfy a loan that is a default. This action is known as a friendly foreclosure because it acts out a mutual agreement between both the lender and borrower. This potentially avoids a lengthy lawsuit.
The deed in lieu of foreclosure has several advantages to both the lender and borrower. The borrower immediately is released from the principal and personal indebtedness with the loan. The borrower also avoids public foreclosure and it doesn’t hurt the borrower’s credit as much as a foreclosure would. The advantages to the lender would be that this process takes less time and cost to take repossession of the property (avoidance of bankruptcy of borrower or vandalism of the property before leaving).
However, the deed in lieu of foreclosure has disadvantages as well. For a lender, all lender rights are gone regarding the Federal Housing Administration (FHA), private mortgage insurance (PMI), or Veterans Affairs (VA). All junior liens are eliminated. And for the borrower, the deed in lieu of foreclosure is still considered unfavorable on their credit report.
Equity Right of Redemption
In many states, the borrower who is in default can redeem their property through equity right of redemption once all the terms have been met. Equity right of redemption gives owners who pay back the lender the amount that is in default, plus all other costs will prevent foreclosure. And in some cases, even after the property was auction off or a sale occurred.
Equity right of redemption also allows other persons who have an interest in the property, e.g. another creditor to pay the full amount that is in default. If another person redeems the property, the borrower will become responsible for that person in the amount that is redeemed.
Statutory Right of Redemption
Some states also allow the borrower who is in default a certain time frame to redeem their foreclosed property, (this period may be up to a year). This time period gives the borrower enough time to obtain the necessary funds to redeem the property. The court may order and appoint a receiver to take control of the property, e.g. maintenance, collect rents, etc. A statutory right of redemption happens after the sales (foreclosure) and an equity right of redemption happens before the sales.
Deed to Purchaser at Sale
The deed to the purchaser at sales is the process whereby, if redemption of the property is not met, the successful winner of the auction or the purchaser of the property takes control of the deed. Government officials, e.g. sheriff, court officer, or trustee executives transfer the deed to the new owner.
In 2008, the U.S. witnessed a financial crisis that led to many real estate properties losing enormous value. In many situations during that time, property owners owned more than the value of the property or what it was worth. This is also known as an upside-down mortgage. A short sale is where the lender permits the borrower to sell the property for less than what it is owed on the property. The short sale must be approved by the lender and the minimum price will also be determined. During the actual sales process, the lender is informed and will need to approve the final sales price of the short sale between the seller and the new buyer. The process usually takes longer than a normal sale, however, many buyers may feel that it is worth the wait.
A lender may approve a loss for a short sale because it may be far better than a typical foreclosure. As previously mentioned, lenders are not in the real estate business, they’re in the lending business. A foreclosure may be lengthy and more costly than a short sale. However, the borrower may not entirely get out from under completely. It may seem like a good deal, but this is not always the case. One final blow is the result of Uncle Sam! The debt that is forgiven will be collected as income in the eyes of the Internal Revenue Service (IRS). Be sure to take that into consideration, due to the fact of a heavy tax bill for that year.
Conclusion: What are the Types of Foreclosures?
There are basically three types of foreclosures; judicial foreclosure that requires the court system to be involved, nonjudicial foreclosure does not require the court system, and strict foreclosure that requires the court but without the lengthy process of auctions, it is simply a transfer of title. There are also redemption periods that can have an impact on the opportunity that the borrow has to obtain the necessary funds to gain back the property. Lastly, a short sale is where a seller can sell the property with the approval of the lender for less than what the property is valued at.
Guttentag, J., The Mortgage Encyclopedia, McGraw Hill, New York, NY
Talamo, J., The Mortgage Answer Book, Sphinx Publishing, Naperville, IL
Cortesi, G., Mastering Real Estate Principles, Dearborn Financial Publishing, Chicago, IL