Image: Home with foreclosure sign in front yard © Ariel Skelley, Stockbyte, Getty Images

Michael Barton was just 19 when he bought his first foreclosure four years ago for $37,000. The Lincoln, Neb., resident said he realized he could pay less on a mortgage than he was spending to rent a six-bedroom house with his brother and three other people.

"I was paying $350 a month in rent and knew there were houses out there that would have a mortgage lower than that," Barton said. "My original mortgage on my first house was $315 a month, and I had my brother living with me paying $350 a month, (so I was) living for free."

Since then, Barton has purchased three more foreclosed properties to fix up and rent out.

By contrast, financial planner Diahann Lassus wasn't in the market for an investment property when she noticed a foreclosure for sale around the corner from her Bonita Springs, Fla., home.

After extensive research and number crunching, Lassus offered the bank 20% less than its asking price -- a discount that reflected the considerable costs necessary to fix up a house that had been empty for two years. Her offer was accepted, so she wound up paying $95,000 cash for a three-bedroom house once valued at $350,000.

The renovations cost more than she had expected -- about $45,000 -- and the return on her investment has been less than what she's making on her stock market investments. But she has "great renters" who are covering her costs, and she expects the home to appreciate over the 10 years or so she plans to own it.

Liz Weston

Liz Weston

Buying a foreclosure can be a great way to get a home for less, whether you're planning to live in the property or rent it out. The supply of foreclosures certainly isn't going to dry up soon, which means plenty of opportunities for home seekers and investors.

Plenty of pitfalls await the unprepared buyer, however.

"A foreclosure is not for everyone," said John Anderson, a longtime agent with Twin Oaks Realty in Golden Valley, Minn., who says about half of his business is short sales and foreclosures. "A lot of buyers are struggling just to get enough money" for a down payment and "don't have $4,000 to replace the carpet and $1,000 to repaint and $2,000 for new appliances."

Even for those who have some spare cash, it might not be enough to buy troubled properties that are too run-down to qualify for Federal Housing Administration or even conventional mortgages. Peeling lead paint can be enough to thwart an FHA loan, while more serious problems, like a roof that needs to be replaced, can stymie a conventional loan. In such cases, only buyers who can pay cash are considered.

"The buyer has to qualify for financing, but the property has to qualify, too," Anderson said. "The seller is not going to let you in to fix the property (before the deal closes), and the new bank won't let you close until the work is done."

Some properties simply need too much work to make much financial sense. A foreclosure might be $15,000 less than a comparable property, for example, but may need $30,000 in repairs and improvements to make it habitable. In such a case, the more expensive property "is a better investment, because the work is already done for you," Anderson said.

"Just because the price is low doesn't mean it's a good deal," he said.

Here are some other things to keep in mind when you consider buying a foreclosure:

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Planning to flip? You might want to rethink that. People can, and do, buy foreclosed houses cheap so they can fix them up for quick resale. In falling markets, though, it can be hard for buyers, particularly amateurs, to do this successfully. If you don't get a steep enough discount or spend too much on repairs or don't find a buyer quickly, what looked like a great deal can become a cash drain. Many investors now are focusing on properties they can rent out for several years, so they can benefit from price appreciation when it eventually returns. Lassus recommends that foreclosure buyers be ready to hang on to a property for seven to 10 years.

Don't expect to automatically get a screaming deal. Some banks slash a property's price for a quick sale, which means you'll get the house for less than comparable homes in the area. Other banks don't offer much, if any, discount, and intense investor interest in a property can lead to a bidding war that drives up the price.