What Is Foreclosure And How Does It Work?

The legal process by which a lender attempts to recoup the amount owing on a defaulted debt by seizing and selling the mortgaged property. The default usually occurs when a borrower fails to make a certain number of monthly payments, but it can also occur when the borrower fails to meet other provisions of the mortgage agreement.

A mortgage or deed of trust contract gives the lender the right to utilize the property as collateral if the borrower fails to comply with the requirements of the mortgage agreement.

The foreclosure process usually starts when a borrower defaults or skips at least one mortgage payment, though it varies by state. The lender then issues a missed-payment notice, indicating that the previous month's payment was not received.

The lender issues a demand letter after the borrower misses two payments. Although this is more serious than a missed payment notice, the lender may still be ready to work with the borrower to make up the missed payments.

After 90 days of missed payments, the lender will send a default notice. The loan is turned over to the lender's foreclosure department, and the borrower usually gets another 30 days to make the payments and get the loan reinstated (this is called the reinstatement period). If the homeowner does not make up the missed payments before the conclusion of the reinstatement period, the lender will commence foreclosing.

The notices that a lender must post publicly, the homeowner's choices for bringing the debt current and avoiding foreclosure, and the timeframe and process for selling the property are all governed by state law.

After a protracted pre-foreclosure process, a foreclosure—the actual act of a lender seizing a property—is usually the last stage. Before foreclosure, the lender may provide a variety of solutions to avoid foreclosure, many of which can mitigate the negative implications of foreclosure for both the buyer and the seller.

Court-ordered foreclosures are the norm in 22 states, including Florida, Illinois, and New York. This is when the lender must go to court to obtain authorization to foreclose by demonstrating that the borrower is in default. If the foreclosure is allowed, the property is auctioned to the highest bidder in an attempt to reclaim the amount owing to the bank, or the bank becomes the owner and sells the property in the usual manner to recoup its losses.

Non-judicial foreclosure, sometimes known as the power of sale, is used by the other 28 states, including Arizona, California, Georgia, and Texas. This sort of foreclosure is usually quicker than judicial foreclosure, and it does not go through the courts unless the homeowner files a lawsuit against the lender.

According to the U.S. Foreclosure Market Report from ATTOM Data Solutions, a property data provider, properties foreclosed in the second quarter of 2021 stayed in the foreclosure process for an average of 922 days. This is a tiny decrease from the previous quarter's average of 930 days, but an increase of 34.5 per cent from the second quarter of 2020's average of 685 days. 

Due to various legislation and foreclosure timelines, the average amount of days varies per state.

Even if a borrower has missed one or more payments, there may still be options to avoid foreclosure. Alternatives include the following:

1. Reinstatement: To get back on track with the mortgage, the borrower can pay back everything they owe (including missed payments, interest, and any penalties) before a set date within the reinstatement period.

2. Short refinance—A short refinance occurs when the new loan amount is less than the outstanding balance, and the lender may forgive the difference to help the borrower avoid foreclosure.

3. Special Forbearance: If the borrower is experiencing a temporary financial hardship, such as medical expenditures or a reduction in income, the lender may agree to lower or suspend payments for a certain period.

If a property fails to sell at a foreclosure auction, or if it never went through one in the first place, the lender—usually a bank—takes ownership and may add it to a portfolio of foreclosed properties, also known as real estate owned (REO).

Bank websites usually have foreclosed properties readily available. Real estate investors may be attracted to such properties because banks often sell them at a lower price than their market worth, putting the lender at a disadvantage.

A foreclosure appears on the borrower's credit report within a month or two following the first missed payment, and it stays there for seven years. The foreclosure will be removed from the borrower's credit report after seven years.