Though foreclosures are down by 26 percent since 2012, they continue to take place across the nation. In fact, according real estate experts RealtyTrac, almost 1.4 million Americans foreclosed on their homes or were served default notices on their mortgages in 2013. And when those houses pop up on the market, they tempt buyers with low(er) prices.

But how does foreclosure actually work? What’s the difference between buying a foreclosed home, purchasing one at auction, and participating in a short sale? And is the lower price tag worth the potential hassle?

In this 3-part series, we’ll take a closer look at how foreclosure works and how it affects homeowners as well as potential buyers.

How do foreclosures happen?

When a homeowner takes out a mortgage, they’re agreeing to pay back not only the amount of the loan (the “principal”), but also any interest that accrues over time. If they miss multiple mortgage payments, it shows the bank that they may not be able to keep up with their end of the bargain. That’s when a foreclosure — the process of the bank repossessing the house — will begin.

The first step: the bank will issue a Notice of Default (NOD). The default notice is the beginning of the “reinstatement period,” during which the homeowner must pay their bills or face foreclosure.

What is a short sale?

During the reinstatement period, homeowners have some options, including negotiating with their bank and working out a short sale. A short sale is when the mortgage company agrees to accept less money than the current owner owes, which means a buyer could pay well below market value.

Because a short sale is typically less damaging to a person’s credit score than foreclosure, this option can be very appealing to a homeowner who can’t afford their mortgage. But, finding a buyer in any market can be tricky, and convincing a mortgage company to settle for less than they’re owed can be a long, slow process.

Prospective homeowners looking to take advantage of a short sale should also be aware that they’ll likely receive the property “as is” — meaning there could be lots of costly home-improvement projects in their future.

When does a house go up for auction?

Typically, if the owner doesn’t catch up on their loan payments (or go the route of a short sale) within roughly 3 months of being served the NOD, they’ll receive a Notice of Sale (NOS). The NOS means that the house is officially in foreclosure and an auction date has been set.

Buying a foreclosed home at auction can be tricky. The minimum bid is set by a foreclosing lender, which means it includes the outstanding loan balance, interest, and additional auction fees. You’ll also likely be expected to have a large chunk of money on hand (at least 10 percent of the total cost) in order to show you’re serious about the purchase.

Additionally, bidders are not allowed to inspect the property, so in a sense, you’re blindly purchasing a home without knowing what kind of shape it’s in. (And, after all that, the bank can still decline your offer on the home.)

A house doesn’t sell at auction — what now?

If the foreclosed home doesn’t sell at auction, the mortgage company becomes the owner, making it a “bank-owned” or “real estate-owned” property. While a foreclosed home may come with a cheaper price tag, it’s not a guarantee and the process of buying one is almost always more cumbersome.

Purchasing a bank-owned home (much like buying a short sale home) can be a long process. When you make an offer on the house, it typically needs to be approved by several shareholders to prove that the bank is getting as much money as they possibly could for the home — which means it’s unlikely that a first offer will be accepted.

Of course, as with all legal proceedings, the process differs slightly state to state, so it’s important to be aware of your local laws.

Next up: homeowners insurance and foreclosure

Stay tuned tomorrow for Part 2 of our Understanding Foreclosure series, where we’ll debunk myths about homeowner’s insurance and foreclosure and explain how to stay protected if you ever find yourself facing foreclosure.

Related links

Understanding foreclosure: what it means for your homeowners insurance
Understanding foreclosure: tips for potential buyers
Are you making this huge homeowners insurance mistake?
10 things to look for when buying a house

Homeowners 101


about Jennifer

A Motor City native, Jennie spent a few years knee-deep in automotive before heading to San Francisco to join the Esurance team as a copywriter. In addition to words, she’s a big fan of running, Detroit Tiger baseball, and the Trader Joe’s cheese aisle.