Thinking of Buying a Foreclosed Property? No Reason to Panic

Last Updated Oct 14, 2010 4:05 PM EDT

Your home is safe. If you bought a foreclosed property in good faith, no court or sheriff will take it away, even if the paperwork turns out to be bad.

The scandal of faulty foreclosures is frightening buyers who took advantage of today's low prices and interest rates. Investors who bought fixer-uppers or rental properties are worried too. If a lender took the home away from its previous owner improperly, will the sale be undone? Is it safe to buy a house out of foreclosure now?

The message from consumer credit experts is: Calm down. "The law strongly protects the finality of foreclosure sales," says Bob Lawless, law professor at the University of Illinois. You get to keep the house, even if the former owner persuades a judge that the foreclosure was improper.

That doesn't sound fair. Why shouldn't the previous owners be reinstalled if the eviction was wrongly done?

The answer is that court systems couldn't operate if final decisions suddenly become open to attack, Lawless says. Furthermore, the buyers have rights, too, once they have the deed in hand. If deeds that were transferred legally could be snatched away, there might be no bidders at foreclosure auctions at all or, at best, drastically lower prices.

If a judge does overturn a foreclosure judgment and the house has already been resold, the previous owner has a claim for damages against the lender or mortgage service company. The new owner won't be told to hand the property back.

None of this prevents the previous owner from suing everyone in sight, including the new owner. But wise lawyers won't do that because they know they'll almost certainly lose. If an unwise lawyer steps in the case, you'll be defended by your title insurance company (you did buy title insurance, right?).

Your only risk is that your title might not be clear. In theory, your insurance company checked it out before you bought. In practice, a gap in the chain of title might have been overlooked. When you sell, the buyer might discover the error. An error might also be introduced after you buy, as investors transfer your loan from one owner to another.

Clearing the title is your insurer's job but it could take several months. Presumably, both you and your buyer won't want to wait that long. Lawyers usually suggest that the sale go through, with the buyer putting some part of the purchase price into an escrow account. When the title is cured, that money will be released. The paperwork problem shouldn't affect the property's price, only the time it takes you to be paid in full.

Some of these title flaws will haunt the real estate market for years. Once again, it's a failure of oversight, regulation, and responsible banking. And once again, consumers and taxpayers pay the price.

More on MoneyWatch:
Foreclosure Mess: What It Means for You
Foreclosure Fraud: How You Can Be Driven to Default Even If You Pay On Time
Who Pays for a Foreclosure Freeze? We the Taxpayers Do
The Foreclosure Mills: How This Could Really Hurt the Housing Market