Good credit, but bad scar on report, how to answer lenders inquiry?

The interest rates you see/hear advertised are almost always Fannie Mae & Freddie Mac loan programs (collectively these are called "conforming" loan programs), however FHA financing also has just as low of interest rates (same with VA & USDA, if you are eligible for either of those).

When a bank takes ownership of a property they had a mortgage on which wasn't paid/was in default it's called a foreclosure.  It doesn't actually need to say that on your credit report, but that is what it is.  In order to apply for FHA financing you'll need to wait 3 years from the foreclosure (when the bank took back the home), and for Fannie Mae/Freddie Mac financing it'd be 7 years.  The exception is if the foreclosure was due to an extenuating circumstance (situation beyond your control, usually related to medical, but can also extend to other non-recurring events that have resulted in a sudden, significant, prolonged reduction in income or a huge increase in financial obligations) - then FHA financing just needs 1 year and Fannie/Freddie financing will be OK with 3 years.

Another situation similar to that is a deed-in-lieu of foreclosure, where you give the bank back the title of the home in lieu of them foreclosing on you... but the bank doesn't take it in that situation, you give it to them.  In that situation FHA still considers it the same severity as a foreclosure, but conforming financing considers it differently, and only requires 2 years from that event (no matter if it was due to extenuating circumstances or not).

So to answer your question, your appropriate response to their information would be to call up your mortgage company that held the mortgage on the home that was taken back from you and ask if they foreclosed on it or if you did a deed-in-lieu of foreclosure - then you will know what situation you are dealing with.