It’s time for another mortgage match-up, with the latest in the series pitting the lesser known “deed in lieu of foreclosure” vs. the more popular short sale.
Nowadays, there are plenty of options to get rid of your home and avoid foreclosure, even if you owe more than the property is currently worth.
By avoiding the full-blown foreclosure process, you can reduce the negative impact to your credit score and ensure the lender won’t come after you for any deficiency balance.
Additionally, you may be able to purchase real estate and qualify for a mortgage much sooner if you go with one of these foreclosure alternatives.
What Is a Deed in Lieu of Foreclosure?
- As the phrase “deed in lieu” suggests
- Instead of the lender pursuing foreclosure and taking your home
- They will allow you to voluntarily deed back your property
- It’s basically a preemptive forfeiture of the home in exchange for some benefits
In short, a deed in lieu of foreclosure is exactly what it sounds like. Instead of foreclosure, you agree to voluntarily deed your property to the lender.
In exchange for this transfer of ownership, the lender will release the associated lien (mortgage), allowing you to move on with your life.
However, banks will only agree to a deed in lieu if you keep the property in good shape and meet some sort of hardship requirements.
The trade-off is that the bank gets a property free from damages typically associated with foreclosure, and they don’t need to deal with costly foreclosure proceedings.
Of course, with home prices much lower now than they once were, properties are often being dumped for less than what is owed on the mortgage.
As a result, the lender may be able to come after you for the deficiency balance, or the shortfall between the current property value and the loan balance, depending on state foreclosure laws.
If this is the case, you may be on the hook for all or part of the shortfall, which clearly isn’t ideal if you can’t even afford your mortgage payments.
It certainly won’t make your tax returns any more pleasant, especially after surrendering the property to the lender.
This is why it’s imperative that you negotiate with the lender to forgive any deficiency balance before agreeing to one of these deed in lieu of foreclosure agreements. And to get it in writing!
You must also do this with any junior liens, or second mortgages (or thirds). If you don’t, those lenders can come after you for any shortfall in certain situations.
Finally, you’ll want to determine if the Mortgage Forgiveness Debt Relief Act applies to your situation.
Even if the lender doesn’t come after you for any money, Uncle Sam still might by way of tax liability. So there are two potential pitfalls you must try to avoid.
Why Choose a Deed in Lieu?
- There are several possible advantages to a deed in lieu
- Including less credit score damage (see chart below)
- A shorter waiting period to get another mortgage in the future
- And less required work (compared with a short sale)
Aside from avoiding an outright foreclosure, a deed in lieu may be the quickest option to part with your home if you don’t qualify for some other form of relief, such as a mortgage refinance or a loan modification.
Instead of being tasked with selling your home and waiting for the bank to accept the short sale offer, you can have the bank take care of it.
However, the bank may still ask that you list the property for a period of time before agreeing to a deed in lieu.
Also, a deed in lieu may not be nearly as bad as a foreclosure with regard to your credit score. It will still hurt your credit, but the impact could be less, assuming there is no deficiency balance.
Credit Score Impact of a Deed in Lieu
Check out the credit score impact of a deed in lieu as opposed to a foreclosure, according to FICO. It’s still not great, but it probably won’t do as much damage as a foreclosure.
On top of that, you’ll be able to qualify for a new home loan in a shorter period of time.
Instead of waiting up to seven years after a foreclosure, you may only need to wait as few as two years if you have extenuating circumstances, or four years under normal circumstances.
Lastly, you may be able to stay in your home with a deed in lieu if the lender offers a “Deed-for-Lease” option, as Fannie Mae and Freddie Mac now do (along with Bank of America). Or you may receive some spending money for relocation costs.
For example, Fannie Mae has a so-called “Mortgage Release” program that provides options such as vacating a home immediately, staying for up to three months rent-free, or leasing the home at fair market rates for up to a year. This can be especially helpful if you have limited monthly income.
They may also provide relocation assistance (up to $3,000 to help you move and find a new residence), while also eliminating your remaining mortgage debt. That sounds a lot better than a foreclosure, doesn’t it?
What About a Short Sale?
- The downside here is that you actually have to do some work
- As the name suggests you’ve got to sell the place
- And you need to do so with the approval of your lender
- This can be time-consuming and a major burden during what is probably already a stressful time
I’ve already written extensively about short sales, which are probably the most popular foreclosure alternative available today.
Put simply, you must convince the lender to allow you to sell your property for less than the associated mortgage balance.
The downside is that you must list your home for sale, which obviously takes work, results in people tracking mud through your home, dealing with annoying real estate agents, and can take many (many) months to finalize.
First off, you need the bank to approve the sale, and secondly, you need to close the deal. It’s a lot more difficult to sell homes these days, so it can be quite a pain.
It’s basically a home sale without the profits at the end, but it might beat the foreclosure process.
However, new rules have sped up short sales, and now that they’re so commonplace, the process can be a lot more effortless.
The result is similar to a deed in lieu in that you are released from the loan once the home is sold, and you avoid foreclosure.
Again, you must ensure that there isn’t a deficiency balance to avoid owing any money on your tax returns after the deal is done.
And if there are second or third liens, they must also be dealt with.
Tip: If you complete a short sale or deed in lieu via the Home Affordable Foreclosure Alternatives (HAFA) program, the deficiency balance must be waived.
The advantages of a short sale are like a deed in lieu in that you can reduce the credit score impact and get a new mortgage sooner. You may also be offered a financial incentive to short sell.
The drawback is that a short sale may be more time consuming and tedious. However, banks are probably more willing to approve a short sale than they are a deed in lieu, especially if there is another mortgage loan is involved.
Though beginning in March, Fannie and Freddie will allow borrowers with illness or the need to relocate for a job apply for a deed in lieu, even if current on their mortgages. This just so happens to be taking place when home prices are on the rise…
In either a short sale or deed in lieu, there are also potential tax consequences, so consult a CPA and/or a lawyer before deciding which choice is best for you, if either. And pay attention to any legal updates on foreclosure laws, as they can change over time.
Read more: Foreclosure vs. short sale