What is "Deed in Lieu of Foreclosure"

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What You Should Know

  • A Deed in Lieu of Foreclosure is an agreement between a property owner and a mortgage lender to transfer the title of a property from the owner to the lender in exchange for relief from mortgage debt.
  • It is considered as the last resort option before foreclosure on the property happens.
  • A deed in lieu of foreclosure and a foreclosure are similar, but they are not identical.

What is “Deed in Lieu of Foreclosure”

For Sale

A Deed in Lieu of Foreclosure is an agreement between a property owner and a mortgage lender to transfer the title of a property from the owner to the lender in exchange for relief from mortgage debt. A property owner may choose to use a Deed in Lieu of Foreclosure since it may be less damaging financially and emotionally than the full process of Foreclosure. A lender and a borrower must enter a deed in lieu of foreclosure agreement voluntarily and in good faith.

Deed in Lieu of Foreclosure is one of the tools that the property owner may use during the pre-foreclosure process. It is considered as the last resort option before foreclosure on the property happens. Individuals usually try to renegotiate the terms of the mortgage with the lender or perform a short sale of the property before accepting the deed in lieu of foreclosure. When an individual agrees to the terms of a deed in lieu of foreclosure, they accept that they lose their property and possibly have to relocate, but in return, they are relieved from the burden of the loan.

OutcomesSolutions Available During Pre-foreclosure
Mortgage RenegotiationShort SaleDeed in Lieu of Foreclosure
Mortgage is ForgivenNoPartially or FullyYes
Property is RetainedYesNoNo
Credit Score DropsYesYesYes, Badly

Definition of Foreclosure

Foreclosure is the legal process by which the lender tries to recover the amount owed on a defaulted mortgage by taking ownership and selling the mortgaged property. Foreclosure is the process that follows pre-foreclosure where the lender tries to recover the debt amount owed through the means that do not relate to the debtor. Depending on the state, two types of foreclosure may take place:

  • Judicial Foreclosure - For a foreclosure process to start, a lender must file a lawsuit against the borrower and win a court hearing.
  • Nonjudicial Foreclosure - A lender may be able to begin the foreclosure process without going through the court system.

Usually, the lender will try to sell the property at an auction or through a REO asset manager during the foreclosure process. Deed in lieu of foreclosure usually happens during pre-foreclosure and before the foreclosure process begins because it is a way for the debtor to be relieved from the debt owed and avoid a long and costly process of foreclosure.

Deed in Lieu of Foreclosure vs Foreclosure

Both a deed in lieu of foreclosure and a foreclosure are similar in their consequences to the buyer, but they are not identical. Deed in Lieu of Foreclosure is a voluntary agreement between the owner and the lender to transfer the rights for the property in exchange for mortgage forgiveness. Foreclosure, on the other hand, does not require an explicit owner’s agreement to start the process of transferring the property rights.

An owner may consider a deed in lieu of foreclosure because it is marginally less damaging to the owner’s credit score than a formal foreclosure, and the mortgage owed is usually forgiven while foreclosure does not guarantee full forgiveness of the mortgage owed. During foreclosure, a lender often chooses to take extra steps to recover the most amount of money possible, which may be more costly than the deed in lieu of foreclosure for the borrower. If the owner still owes a deficiency balance after the foreclosure, the lender has an option to file a separate lawsuit to collect the amount owed through wage or bank account garnishments.

A lender may accept or decline a deed in lieu of foreclosure depending on different factors:

  • Delinquency on Payments and Amount Owed - The lender always looks at how many delinquent payments there are and what is the outstanding balance on the mortgage. Before deciding on whether the lender would accept the terms of a deed in lieu of foreclosure, the lender must understand if the deal is in their interest to forgive the loan in exchange for the property. The larger the amount owed, the less likely for the lender to accept the deed in lieu of foreclosure.
  • Estimated Value of the Property - Another important factor in determining whether the lender would accept the terms of the deed in lieu of foreclosure is the amount they expect to recover from the sale of the property. The estimated value of the property, in this case, works as a benchmark for determining the amount of profit or loss a lender may face when going with the deed in lieu of foreclosure. As a rule of thumb, the larger the value, the more likely for the lender to accept the deed in lieu of foreclosure.
  • Market Conditions - A lender is also interested in how long it might take for the property to sell and how much of a discount the lender might have to offer to sell the property within the required time. These factors are more uncertain than the amount owed or the estimated value of the property, but they are important in making a decision.
  • Additional Terms - Sometimes a lender may be open to accepting the deed in lieu of foreclosure if the owner chooses to rent the property for the specified time. This way the lender may have sufficient cash inflow to cover the losses associated with the default and the sale of the property.

Advantages and Disadvantages of Deed in Lieu

There are two sides to the deed in lieu of foreclosure agreement. Both the borrower and the lender will need to consider the pros and cons of a deed in lieu agreement. It often happens that the borrower may find a much better solution to reverse the foreclosure process while a lender often may not accept the agreement because they may recover more funds owed with a formal foreclosure process.

Deed in Lieu for a Borrower

Pros:

  • Forgiveness of the mortgage owed. The owner usually gets freed from any financial obligations related to the mortgage owed. There are some exceptions to it if the owner agrees to pay a part of the debt with the lieu deed transaction. This can only happen voluntarily and in good faith.
  • Avoidance of publicity, expense, and time involved with the formal foreclosure process. The owner’s financial position is not disclosed to the public unlike during a formal foreclosure process. This lets the borrower avoid embarrassment. In addition to that, a deed in lieu helps avoid all costs and time spent on a foreclosure process.

Cons:

  • Loss of the property and all equity accumulated with the property. The property is being transferred to the lender fully. There is no residual amount that an owner may claim after the process is complete.
  • Payment of taxes related to property transfer. Depending on the state, the owner may have to pay all applicable taxes that relate to a Real Estate transaction

Deed in Lieu for a Lender

When a lender is faced with a borrower who is in pre-foreclosure, their main goal is to recover as much as possible from the debt owed and also mitigate any costs related to a foreclosure process. A lender has a few options to choose from before offering a Deed in Lieu of Foreclosure to their client. Generally speaking, the lender may be able to recover more from the borrower through foreclosure, but the costs and time associated with foreclosure may make the deed in lieu option look more attractive. If the lender chooses to pursue a deed in lieu of foreclosure, the borrower must agree to it voluntarily and in good faith. Pushing a borrower to agree to the deed in lieu may lead to legal consequences for the lender.

Pros:

  • The lender becomes the owner. The lender can control the operations and take immediate steps to maximize the value of the property and use all of its cash flows.
  • The transaction is quickly and easily negotiated. It lets the lender get the property at a good price and with the title ready. With the title, the lender can get the property marketed and sold very quickly.
  • Publicity, time, and costs of a formal foreclosure process are avoided. It costs a lot for lenders to pursue foreclosure, which makes the deed in lieu of foreclosure a very attractive option very often.
  • The property transfer cannot be set aside by bankruptcy court. If the owner’s equity is smaller than the debt owed, then the deed in lieu transaction cannot be postponed by the court. The lender may lose a lot of time during a formal foreclosure process trying to get the property title if the owner files for bankruptcy.

Cons:

  • Sometimes a lender may be faced with an offer of a partial transfer of the ownership. In this case, the ownership title becomes unclear, and the lender may not be able to foreclose the property for a long time.
  • There may be some outstanding liens in the name of the property such as unpaid property taxes and other fines. The lender needs to conduct proper due diligence before accepting the deed in lieu of foreclosure.

Other Solutions Available During Pre-foreclosure

A deed in lieu of foreclosure is the tool that is used as a last resort during the pre-foreclosure process because it is the most damaging solution to avoid foreclosure. There are two other solutions that an owner should consider before choosing to proceed with a deed in lieu of foreclosure:

  • Loan Modification - The first way to avoid foreclosure that an owner should try is to renegotiate the terms of the mortgage. In this case, the lender can offer term modifications or changes in the payment schedule that may help the owner to meet financial obligations in the long term. There is a high chance that the lender chooses this option because the foreclosure process is a long and expensive process for the lender as well, so it is often easier to simply modify the terms of the loan.
  • Short Sale - The other way to avoid foreclosure and a deed in lieu of foreclosure is to conduct a short sale of the property. Depending on the state, the details of how a short sale is conducted may change. As a general concept, the owner tries to sell the property privately for the amount of the debt owed. In this case, the amount is paid directly to the lender. If the property is sold for more than the amount owed, then the owner can get some equity out of the property.

These solutions may be much more beneficial than a deed in lieu of foreclosure for both the lender and the borrower. Looking into these options and closely communicating with the lender may help the owner to keep the property, minimize the effect of missing payments on their credit score and reverse the process of foreclosure. A deed in lieu of foreclosure should be saved as a last resort option when the borrower cannot keep making payments or sell the property. Before agreeing to the deed in lieu, it is important to understand the effects on the borrower’s credit score and their ability to purchase a property down the road.

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