Definitions for Deal-Seeking Buyers: Short Sales, Foreclosures, and REO Homes

You may have heard that short sales, foreclosures, or bank-owned properties offer great opportunities for a steal, but what do these different terms mean, and how does the homebuying transaction work for each? What’s the difference between buying a short sale vs. a foreclosure, and where can the best deals be had?

Here we cover what you need to know about buying distressed homes, from start to finish. You will learn what each stage of the process looks like as we define the different terms clearly. By the end, you’ll have all the information you need to seek out these properties, determine if a deal is good or not, and make an offer.

A photo of a house represents the topic of short sales and foreclosures.
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Distressed or short sales

The path to foreclosure begins with a homeowner struggling to make their mortgage payments. When a homeowner can’t make their payments, they may either try to sell their home before they get too far behind on their mortgage, or they could simply let the loan go into default. If the home is sold before it’s foreclosed without working with the lender, then it’s known as a distressed sale.

A distressed home for sale probably doesn’t look any different than any other home on the market, though there is a possibility that it will be more run down. If the homeowner has had financial difficulties for several months or longer, they likely haven’t been able to afford maintenance. That said, such a home can likely be purchased for fair-market value. One thing to keep in mind, though, is that the seller probably isn’t going to have cash reserves available to fix any issues uncovered in the inspection before closing.

A distressed sale may be the best-case scenario for the seller. If they are unable to make payments, but they are able to sell the home for an amount equal to or greater than what they owe on it, then they leave with their credit score intact — and possibly some extra money in their pocket.

If, however, the homeowner is underwater on the loan, meaning that they owe more on the mortgage than the home is worth, they can appeal to their bank to allow a short sale (which is a specific type of distressed sale). This means the purchase price of the house will likely not be enough for the seller to fully pay off their mortgage.

According to Troy Walseth, a Florida real estate agent with over 27 years experience, banks don’t typically allow a homeowner to go straight to a short sale unless the amount still owed is more than the current market value of the home. “The banks will actually require it to physically be on the market for a certain amount of time with a contract through a real estate agent,” he explains. If the home fails to sell at market value, then the price may be lowered so that the homeowner can more quickly be free of their debt burden.

Short sales are typically listed on the market just like any other home; you might see terms like “subject to bank approval” that indicate you’re looking at a short sale. These deals also tend to take longer than a normal transaction, and there’s no guarantee the seller’s lender will accept the offer.

In order for the bank to agree to a short sale, the seller will often need to prove financial hardship in addition to attempting to sell the property at market value for a specified period of time.

Purchasing a home in a distressed or a short sale can net you a good deal, and the seller is often very motivated to get out from under their financial burden. In some cases, however, these homes may be fixer-uppers, so always be sure to get a full home inspection, and don’t take any shortcuts in the process.

More about the preforeclosure process

If a homeowner cannot pay their mortgage, but does not want to sell their home, then after three months of non-payment, the home may enter preforeclosure. The bank or lender will file a notice of default, and the homeowner will be notified that if they fail to catch up on missed payments in a specified amount of time (which varies by state), their home will revert to the bank’s ownership, and it will go to auction.

Sometimes this legal action will motivate a homeowner to sell, and they will list the home on the market. This could end up being either a distressed or short sale, as described above. In other circumstances, however, the homeowner does not want to leave the home and may choose to stay through the process of eviction and foreclosure.

A savvy buyer may decide to look at preforeclosure listings either themselves or with the aid of a real estate agent. When a home is on the market, you may have to compete with other potential buyers. But by seeking out a preforeclosure, you may not only forego the competition, but it’s also sometimes possible to negotiate a good deal if the homeowner is anxious to resolve their financial difficulties.

Keep in mind, however, that some homeowners might not be happy to hear from you. It’s worth noting that when a home is in preforeclosure, you cannot bypass the homeowner and attempt to negotiate a sale through their bank. The homeowner must agree to sell.

You may choose to reach out to a homeowner yourself, but it’s usually best to have a real estate agent with experience make contact for you. With regards to the homeowner, according to Walseth, “About 30% of the time, they are open to a discussion about it, and about 70% of the time, they say, ‘No, we have that covered.’”

An ethical real estate agent may also let the homeowner know that forbearance and refinancing may be options to help them out of their situation, and that they don’t necessarily have to sell.

A photo of a paddle illustrates the topic of home auctions.
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Foreclosure and auction

Further along the path of mortgage non-payment is the eventual foreclosure itself. When this occurs, the home goes up for auction, and the homeowners are legally evicted.

Auction notices are listed publicly and can be found online or in the newspaper. They often occur at courthouse steps with the local sheriff as the auctioneer. The lender will set the opening bid, and then interested buyers can bid from there.

How a home is purchased at an auction is very different from a traditional home purchase. You are typically required to have cash in hand (a cashier’s check and/or proof of funds) for the purchase price of the house and usually cannot get a mortgage loan for the property. You aren’t able to inspect the property beforehand, either.

As such, purchasing a home at auction almost always requires that you have enough money in the bank to purchase it outright — and that you are willing to take on the risk that comes with a lot of unknowns about the property. Most people who attend these auctions are home flippers: people who purchase homes, fix them up, then sell them at a profit.

Every state has slightly different foreclosure rules. In some states, you might have a couple of extra days to pay for the full amount that you bid, but you’ll need to provide at least the earnest money or down payment immediately, and you’ll have to secure any remaining funds within 48 hours.

It’s also possible that the former owner is still occupying the house when it goes to auction, and if they don’t leave, you may have to work directly with the former owner or go through the formal eviction process to get them out of the house.

A photo of a house illustrates the topic of short sales and foreclosures.
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How a house becomes bank-owned

Sometimes the lender won’t get the minimum amount they want for the house at the auction — or nobody will bid on the house at all. If the house doesn’t have a new owner by the end of the auction, then the bank or lender takes possession of the property. At this point it is now called a bank-owned or real estate-owned (REO) property. For all practical purposes, the home can be thought of as being “back on the market” and available for purchase.

The big difference between purchasing an REO property and a standard home purchase is that finding high-quality homes or homes that are right for you isn’t always easy; supply might be limited in your area. Plus, instead of dealing with a human seller, you’ll be making your offer to and negotiating with a bank, which can be cumbersome. You may be able to streamline the process a bit if you can get preapproved by the same lender that currently owns the house.

That said, if you do find an REO property that suits your needs, you can usually get a pretty good deal, price-wise. The bank is often a motivated seller, and working with a motivated seller gives you more negotiating power as a buyer. You could even end up being able to afford a bigger house, or a house in a nicer neighborhood, than you otherwise would.

However, REO properties may be distressed and in need of repair, and while the bank may be willing to make small concessions or fixes to items discovered during an inspection, they are often less flexible than a regular seller. These sales can sometimes take much longer than a standard real estate transaction as well.

A photo of a house illustrates the topic of short sales and foreclosures.
(Source: Stephen Leonardi / Unsplash)

Where HUD Homes come from

If a homeowner with a government-backed loan defaults on their mortgage, resulting in foreclosure, it’s possible that the U.S. Department of Housing and Urban Development (HUD) will take possession of the property.

HUD’s Good Neighbor Next Door program may offer these repossessed homes for sale at a 50% discount from list price to law enforcement officers, teachers, firefighters, and emergency medical technicians provided they agree to live in the property for at least 36 months (three years).

Good Neighbor Next Door homes are those located in so-called revitalization areas. The idea behind this program is to offer incentives for “good neighbors” to move into areas and contribute to community revitalization.

If you want to purchase a HUD home either through an incentive program, or just in general, you can find listings online at the HUD Homes store.

A rundown house illustrates the topic of short sales and foreclosures.
(Source: Malin / Unsplash)

From first missed payment to REO: A summary

Hopefully at this point, the terminology has become clearer, but here’s a quick refresher if you need it:

  • Distressed sale: When a homeowner needs to sell quickly, and potentially (but not always) at a loss.
  • Short sale: A type of distressed sale in which the sales price is less than what the homeowner owes on the property.
  • Preforeclosure: When the homeowner has missed three consecutive payments, the bank or lender files a notice of default. Homes in preforeclosure are publicly listed. In order to purchase a home in preforeclosure, you must contact the homeowner; however, they are not required to sell the home.
  • Foreclosure: Process by which the bank or lender forces the sale of the property at an auction after the owner has not made payments for a specified period of time.
  • Foreclosure auction: A public event in which investors or buyers may bid on a foreclosed home. You will not likely be able to inspect or see the home prior to the auction. You typically cannot get a mortgage loan for a home purchased at a foreclosure auction.
  • Bank-owned: Homes that do not sell at auction become owned by the bank. These homes are generally listed for sale, often as-is, on the bank’s website.
  • REO: Stands for real estate owned; this is the same thing as bank owned.
A photo of a home in disrepair illustrates the topic of short sales and foreclosures.
(Source: Dan Meyers / Unsplash)

Drawbacks to buying a short sale vs. foreclosure vs. REO home

If you want to purchase a home during any part of the foreclosure process, it may be possible to get a good deal, but it’s also quite possible that you don’t end up with that great of a deal at all.

Keep in mind that the bank, who holds the mortgage, wants to get their money on the house. They want the homeowner to sell it at fair-market value, if at all possible, and they won’t want to go much lower. And after the property becomes bank-owned, they are still hoping to get the home’s market value from you as the buyer.

Remember that homes at different stages of the foreclosure process might be in disrepair. A homeowner who can’t pay their mortgage often can’t pay for upkeep, either. So when purchasing such a home, you may need to account for this and set funds aside for necessary repairs.

Depending upon where the home is in the foreclosure process, purchasing it may require additional paperwork or a longer time frame. You may also be limited in what you can request from the seller or bank, or in your ability to inspect the home fully.

A photo of a person on a cell phone illustrates the benefit of working with a real estate agent on short sale and foreclosure purchases.
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Partner with a top agent

In order to make sure you don’t end up on the wrong end of a distressed sale or purchase of a bank-owned property, it is best to partner with a real estate agent. You want someone with the experience and the connections to both offer you advice and keep your best interests in mind. Find a top agent near you today using our agent finder.

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