Understanding Foreclosure

Understanding Foreclosure article image.

Foreclosure happens when a borrower fails to keep up their mortgage payments, and the lender who issued the loan takes possession of the property and sells it to try to recoup the funds it lent.

What Happens When a House Is Foreclosed?

Foreclosure is a legal option for all mortgage lenders, but there is no universal timeline for it. The process generally involves the following steps, in this order, but time intervals can vary and some steps may differ by jurisdiction and lender:

  1. Within two to three weeks after missing your first mortgage payment, you'll get a letter from the lender indicating payment is past due and outlining steps they may take (up to and including foreclosure) if your payments are not brought up to date. Many lenders provide a grace period of 10 to 15 days during which you can make a late payment without any penalty.
  2. If you miss a second consecutive payment, you will likely get additional letters from the lender, as well as phone calls and emails. The bank may impose late-payment penalties that must be paid along with overdue payments to bring your loan back into good standing.
  3. After a third straight missed payment (that is, after you've gone 90 days past due on your loan), you may get a notice of intent to foreclose in another 30 days. The lender may also post your name on a public list of debtors who are subject to foreclosure.
  4. After 120 days of nonpayment, the lender may initiate foreclosure. In some states this requires a court proceeding, during which a judge must see proof of loan default to authorize seizure and sale of the property, which can take a year or longer to finalize. In other jurisdictions, the process can take just a few weeks.

Ultimately, the foreclosure process forces all of a home's occupants to vacate the property. The locks will be changed and premises will be secured as the property is prepared for auction or direct resale to a new buyer.

Differences in local laws are not the only factors that can affect the foreclosure timeline. Foreclosure policies also vary from lender to lender, and can be affected by the local housing market and economic conditions, as lenders may be somewhat slower to press foreclosure proceedings in markets where real estate sales are sluggish.

How Does a Foreclosure Impact Your Credit?

A month or two after a foreclosure order is issued, a foreclosure entry will typically appear on your credit report, and will remain there for seven years from the date of the first missed payment that culminated in foreclosure.

A foreclosure is considered a serious derogatory event in your credit history, second only to bankruptcy in terms of severity. Many creditors won't even consider applicants who have foreclosures on their credit reports, while some will disregard foreclosures that are several years old, if the applicant meets the rest of their lending criteria.

Foreclosures have a negative impact on credit scores as well, but as with other negative credit report entries, the number of points by which they'll lower your score depends in large part on how high your score was before the foreclosure and how many other negative entries you have on your credit report.

Missed payments hurt credit scores more than any other single factor, and foreclosures typically occur only after at least four successive missed payments, which means your credit scores likely will have fallen significantly before the foreclosure appears on your credit report. (If you are missing payments on other debts as well, this of course has a compound effect.) All that said, it would not be unusual for a foreclosure to cause a FICO® Score drop of 100 points if your FICO® Score is in the mid-to-high 600s, and a drop of 150 points or more if your score is 750 or higher.

Alternatives to Foreclosure

Generally speaking, lenders prefer to avoid foreclosure whenever possible. Removing occupants and reselling a property is expensive and time-consuming, and it is not the business home lenders want to be in. Every communication the lender issues following the first missed payment will have a contact name you can use to discuss your situation with a lender representative. Taking advantage of that option is almost always in your best interest. You may be able to negotiate a new payment plan with the lender (for which you should expect to pay higher interest and fees in exchange for a more manageable monthly payment). If that doesn't allow you to stay in the house long term, it could at least give you time to sell it before foreclosure occurs.

If your local housing market has slowed, or property values have fallen and you're "upside-down" on the loan—that is, you owe more on your mortgage than the market value of the house—you may also be able to get the lender to agree to a short sale. In a short sale, you sell the house for as much as you can get and the lender accepts that sale amount as settlement of your loan. A short sale is far from ideal. It leaves you with no net proceeds from the sale of the home and, because you didn't settle your mortgage under its original payment terms, you'll get a negative entry on your credit report, but one that's less severe than a foreclosure.

How Does a Foreclosure Sale Work?

While foreclosures are very bad news for borrowers who lose their homes, they can be great opportunities for homebuyers with above-average tolerance for risk and willingness to put some work into potentially distressed properties. Foreclosed homes, sold in as-is condition at auction or directly from a lender in the process of seizing the property, can be significant bargains, but it's important to know the potential pitfalls before you venture into that market.

Foreclosure is a potentially devastating experience that borrowers and lenders prefer to avoid at all costs. If you experience a foreclosure, you can expect a significant blow to your credit that will likely take several years to recover from. Your best bet in that case is to take steps as soon as possible to begin rebuilding your credit. With time and patience, you can rebound from a foreclosure.