What Is Pre-foreclosure?

Pre-foreclosure refers to the first phase of a legal proceeding that ultimately can conclude in a property being repossessed from a defaulted borrower. The lender files a notice of default on the property in pre-foreclosure because the borrowing owner exceeds the contractual terms for delinquent payments.

A notice of default informs the borrowing owner that the lender is pursuing legal actions toward foreclosure. Borrowers have a few options available if they find themselves in pre-foreclosure. Lenders may even be willing to negotiate with them to avoid moving to the foreclosure phase.

How Pre-foreclosure Works

When a home buyer takes out a loan to purchase a property, they sign a contract with the lending institution to repay the mortgage loan according to a contractual agreement, typically with monthly installments. Monthly payments are usually structured to cover a portion of principal and interest payments on the mortgage.

Standard mortgage contracts are often structured to be in default if a borrower fails to make payments for three consecutive months. At that point, the lender is usually contractually authorized to begin pre-foreclosure.1 When this happens, the borrower receives a copy of a notice of default, which is also made a matter of public record, through a filing with the court. This action begins the pre-foreclosure process, which can take anywhere from weeks to more than a year, as it varies by state and is subject to a court proceeding.2

There are several standard steps to a foreclosure proceeding. The notice of default kicks off the proceeding in the pre-foreclosure phase. In general, the lender needs court approval, which must be given by a judge, for their lien on a property.

Lenders are often more willing to negotiate backdated payments and possible loan modifications in the pre-foreclosure stage of a proceeding to avoid paying what can be extensive foreclosure proceeding costs. If foreclosure is granted and a foreclosure eviction notice is authorized, then the lender can move toward a public auction or trustee sale.

Short Sales of Pre-foreclosure Homes

A pre-foreclosure home that a borrower puts up for sale is typically referred to as a short sale. The sale can be a private transaction between the homeowner and the buyer, but the buyer’s offer usually must be approved by the bank before the sale can be finalized. The purchase price may be less than the outstanding loan balance, which is why the sale is said to be short.5

Keep in mind that not all short sales are pre-foreclosures. Homeowners who know they are in trouble sometimes elect to sell their properties by any means possible before reaching pre-foreclosure. A buyer can have a pre-foreclosed home inspected before making an offer on it. The buyer could be an investor looking to purchase the property for less than its fair market value (FMV) and then sell it at a higher price for a profit.

If the homeowner lists the property for sale through a real estate agent, then prospective buyers will contact the listing agent. In any short sale, the lending bank will likely need to be involved and may hire one or more real estate brokers or attorneys of their own, particularly to prepare a broker price opinion.

Advantages and Disadvantages of Pre-foreclosure Sales

A home can be sold during the pre-foreclosure phase, which can be a win for all parties involved. By selling, the homeowner avoids the damage that a foreclosure would have on their credit history. The buyer can usually snag the property for below market value. The lending institution doesn’t have to pay the costs of a foreclosure proceeding or sell the property itself.

But selling a property independently is not necessarily easy, mainly since the seller must abide by legalities and disclosure requirements. Buyers of pre-foreclosed homes will need to be aware of any property liens or unpaid taxes on a home because these could potentially be transferred to the new owner without full disclosure or properly documented clauses.

If the homeowner does not make the past-due (and ongoing) mortgage payments, negotiate a modification, or sell the home during the pre-foreclosure period, the lender will eventually be granted authorization of their lien on the property. When this happens, they can evict the owner, subsequently selling the property. At this point, the bank owns the property and is more likely to try to sell the property at an even lower price rather than maintain its ongoing expenses, such as taxes and insurance.

COVID-19 Mortgage Relief

There were a series of steps taken to protect struggling homeowners affected by the COVID-19 pandemic in 2020 and 2021.

• The Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law on March 27, 2020, putting an eviction and foreclosure moratorium in place for government-backed mortgages through Dec. 31, 2020.7
• This was extended through Jan. 31, 2021.
• The moratorium was further extended by President Joe Biden, by executive order on his first day in office, until at least March 31, 2021.8
• On Feb. 16, 2021, the moratorium was extended to June 30, 2021.9
• On June 24th, it was extended for the final time to July 31, 2021.10
• As of March 1, 2022, only certain states have extended the moratorium, such as Washington, D.C. (extended to Sep. 30, 2022). 11

The executive order also made qualifying multifamily property owners eligible for forbearance. If a claim is approved, then government-backed mortgage borrowers were allowed to defer payments for up to 360 days, avoid late payment fees, avoid eviction from their home, defer any foreclosure proceedings already in process, and halt the pre-foreclosure phase for any new proceedings.7

In addition, private lenders were advised to work with borrowers, making loan modifications more easily accessible. In 2021, rates fell to unprecedented lows, making refinancing a viable option for any mortgage borrower who hasn’t previously refinanced within the last few months and is contractually allowed to do so under their current mortgage terms.12 However, Federal Reserve Chairman Jerome Powell has stated that interest rates will rise in the spring of 2022.13

The Bottom Line

Pre-foreclosure can be an important phase because the lender may be open to a last-rights negotiation on delinquent debt for the borrower. The borrower often has a final opportunity to potentially reverse the default status by making up late payments, negotiating a modification, or possibly opting to sell the property before it reaches a final foreclosure eviction.