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Guide To Understanding Foreclosure
Foreclosure is the equitable proceeding in which a bank or other secured creditor sells or repossesses a parcel of real property (immovable property) due to the owner's failure to comply with an agreement between the lender and borrower called a "mortgage" or "deed of trust". Commonly, the violation of the mortgage is a default in payment of a promissory note, secured by a lien on the property. When the process is complete, it is typically said that "the lender has foreclosed its mortgage or lien."
Types of Foreclosure
The mortgage holder can usually initiate foreclosure anytime after a default on the mortgage. Within the United States, several types of foreclosure exist. Two are widely used, with the rest being possibilities only in a few states.
The most important type of foreclosure is foreclosure by judicial sale. This is available in every state and is the required method in many. It involves the sale of the mortgaged property done under the supervision of a court, with the proceeds going first to satisfy the mortgage, and then to satisfy other lien holders, and finally to the mortgagor. Because it is a legal action, all the proper parties must be notified of the foreclosure, and there will be both pleadings and some sort of judicial decision, usually after a short trial.
The second type of foreclosure, foreclosure by power of sale, involves the sale of the property by the mortgage holder not through the supervision of a court. Where it is available, foreclosure by power of sale is generally a more expedient way of foreclosing on a property than foreclosure by judicial sale. The majority of states allow this method of foreclosure. Again, proceeds from the sale go first to the mortgage holder, then to other lien holders, and finally to the mortgagor.
Other types of foreclosure are only available in limited places and are therefore considered minor methods of foreclosure. Strict foreclosure is one example. Under strict foreclosure, when a mortgagor defaults, a court orders the mortgagor to pay the mortgage within a certain period of time. If the mortgagor fails, the mortgage holder automatically gains title, with no obligation to sell the property. Strict foreclosure was the original method of foreclosure, but today it is only available in a few states, such as Connecticut, New Hampshire and Vermont.
The concept of acceleration is used to determine the amount owed under foreclosure. Acceleration allows the mortgage holder the right when the mortgagor defaults on the mortgage to declare the entire debt due and payable. In other words, if a mortgage is taken out on property for $10,000 with monthly payments required, and the mortgagor fails to make the monthly payments, the mortgage holder can demand the mortgagor make good on the entire $10,000 of the mortgage.
Virtually all mortgages today have acceleration clauses. However, they are not imposed by statute, so if a mortgage does not have an acceleration clause, the mortgage holder has no choice but to either wait to foreclose until all of the payments come due or convince a court to divide up parts of the property and sell them in order to pay the installment that is due. Alternatively, the court may order the property sold subject to the mortgage, with the proceeds from the sale going to the payments owed the mortgage holder.
Foreclosure by Judicial Sale
Foreclosure by judicial sale requires the mortgage holder to proceed carefully in order to ensure that all affected parties are included in the court case, so the purchaser of the foreclosed property receives valid title to the property.
The process of foreclosure is lengthy and the timeframes for when the lending institution begins the process vary from state to state. Other factors, such as the increasing availability of personal loans for owners facing foreclosure, present homeowners with foreclosure avoidance options. Websites which connect individual borrowers and homeowners to individual lenders are increasingly used as mechanisms to bypass banks while meeting payment obligations for mortgage providers. The increase in the number of foreclosures in the United States has led to more loan listings which are designed to forestall or prevent foreclosure.
In the United States, there are two types of foreclosure in most common law states. Using a "deed in lieu of foreclosure," or "strict foreclosure", the bank claims the title and possession of the property back in full satisfaction of a debt, usually on contract. In the proceeding simply known as foreclosure (or, perhaps, distinguished as "judicial foreclosure"), the property is exposed to auction by the county sheriff or some other officer of the court. Many states require this latter sort of proceeding in some or all cases of foreclosure, in order to protect any equity the debtor may have in the property, in case the value of the debt being foreclosed on is substantially less than the market value of the immovable property (this also discourages strategic foreclosure). In this foreclosure, the sheriff then issues a deed to the winning bidder at auction. Banks and other institutional lenders typically bid in the amount of the owed debt at the sale, and if no other buyers step forward the lender receives title to the immovable property in return.
Other states have adopted non-judicial foreclosure procedures, in which the mortgagee, or more commonly the mortgagee's attorney or designated agent, gives the debtor a notice of default and the mortgagee's intent to sell the immovable property in a form prescribed by state statute. This type of foreclosure is commonly referred to as "statutory" or "non-judicial" foreclosure, as opposed to "judicial". With this "power-of-sale" type of foreclosure, if the debtor fails to cure the default, or use other lawful means (such as filing for bankruptcy which provides a temporary automatic stay to the foreclosure proceeding) to stop the sale, the mortgagee or its representative will conduct a public auction in a similar manner as the sheriff's auction described above. The highest bidder at the auction becomes the owner of the immovable property free and clear of any interest of the former owner but the property may be encumbered by any liens superior to the mortgage being foreclosed (e.g. a senior mortgage, unpaid property taxes etc). Further legal action, such as an eviction may be necessary to obtain possession of the premises.
"Strict foreclosure" is an equitable right available in some states. The strict foreclosure period arises after the foreclosure sale has taken place and is available to the foreclosure sale purchaser. The foreclosure sale purchaser must petition a court for a decree that will cut off any junior lienholder's rights to redeem the senior debt. If the junior lienholder fails to do so within the judicially established time frame, his lien is cancelled and the purchaser's title is cleared. This effect is the same as the strict foreclosure that occurred at common law in England's courts of equity as a response to the development of the equity of redemption.
In most jurisdictions, it is customary for the foreclosing lender to obtain a title search of the immovable property and to notify all other persons who may have liens on the property, whether by judgment, by contract, or by statute or other law, so that they may appear and assert their interest in the foreclosure litigation. In all US jurisdictions a lender who conducts a foreclosure sale of immovable property which is the subject of a federal tax lien must give 25 days' notice of the sale to the Internal Revenue Service: failure to give notice to the IRS will result in the lien remaining attached to the immovable property after the sale. Therefore, it is imperative that the lender obtain a search of the local Federal Tax Liens so that if the persons or companies involved in the foreclosure have a federal tax lien filed against them, the proper notice to the IRS will be given. A detailed explanation by the IRS of the Federal Tax Lien process can be found here.
When a bank auctions a repossessed property, they will typically set the starting price as the remaining balance on the mortgage loan. This is not usually the case in the state of Alabama.
In the case where the remaining mortgage balance is higher than the actual home value, known as an Upside-down mortgage, the bank is unlikely to attract auction bids at this price level. A house that went through foreclosure auction and failed to attract any bids becomes property of the bank. It is called "REO" (real estate owned). The bank will typically try to sell it at a loss later through standard channels.
Further Borrower's Obligations
Mortgagor is required to pay for mortgage insurance, or PMI, for as long as the principal of his primary mortgage is above 80% of the value of his property. In most situations, insurance requirements are sufficient to guarantee that the lender will get all his money back, either from foreclosure auction proceeds or from PMI.
Nevertheless, in an illiquid real estate market or following a significant drop in real estate prices, it may happen that the property being foreclosed is sold for less than the remaining balance on the primary mortgage loan, and there's no insurance to cover the loss. In this case, the court overseeing the foreclosure process may enter a deficiency judgment against the mortgagor. Deficiency judgment is a lien that obligates the mortgagor to repay the difference. It gives lender a legal right to collect the remainder of debt out of mortgagor's other assets (if any).
There are exceptions to this rule, however. If the mortgage is a non-recourse debt (which is often the case with residential mortgages), lender may not go after borrower's assets to recoup his losses. Lender's ability to pursue deficiency judgment may be restricted by state laws. In California and some other states, original mortgages (the ones taken out at the time of purchase) are typically non-recourse loans, however, refinanced loans and home equity lines of credit aren't.
If lender chooses not to pursue deficiency judgment and write off losses, or is not allowed to do so because of the mortgage being non-recourse, borrower may be liable to pay taxes on the amount being written off as if it was his income.
Any other loans taken out against the property being foreclosed (second mortgages, HELOCs) are "wiped out" by foreclosure (in the sense that they are no longer attached to the property), but borrower is still obligated to pay them off if they are not paid out of foreclosure auction's proceeds.
Some individuals and companies are engaged in the business of purchasing properties at foreclosure sales. Distressed assets (such as foreclosed property or equipment) are considered by some to be worthwhile investments because the bank or mortgage company is not motivated to sell the property for more than is pledged against it.