What Is a Deed in Lieu of Foreclosure? A Guide

The COVID-19 pandemic caused significant economic damage that will take years to calculate and decades to repair. In response, the United States government created several loan modification programs to help people stay in their homes despite their mortgage debt and prevent an unprecedented number of foreclosures.

These programs ended in the summer of 2021, and since then, the total number of foreclosures has increased dramatically due to financial hardship.

If you fall behind on your bills, it's essential to avoid foreclosure during your repayment plan, as it can seriously impact your credit. Although most government programs have ended, some options are available to help limit foreclosure damage or even allow you to stay in your home while catching up on your bills to your loan servicer.

A deed in lieu of foreclosure may not be ideal, but it is a much better option than going through the lengthy and expensive foreclosure process and losing ownership of the property.

What Is a Deed in Lieu of Foreclosure?

A deed in lieu of the foreclosure process is an official agreement made between a mortgage lender and a homeowner where the property's title is exchanged in return for relief from the loan debt. The terms of the agreement are that the title of the property will be transferred to the mortgage lender by request instead of a court order. Since the borrower will turn over the deed to the mortgage creditor from the mortgagee, there will be no need to enter into the process of foreclosure, saving time, money, and stress for both parties.

Although a deed in lieu of foreclosure is preferable to a foreclosure, it does come with some consequences. The largest downside is that a deed in lieu of foreclosure will appear on the homeowner's credit report for four years. There may also be specific terms and conditions included in the agreement that will require fees to be paid or actions to be taken. It’s important to remember that a deed in lieu of foreclosure is a compromise made by a lender, and they are under no obligation to agree to one. That allows them to set favorable terms that might get costly for the homeowner.

When Is a Deed in Lieu of Foreclosure Used?

Seeking a deed in lieu of foreclosure isn’t an ideal situation and should only be used as a last resort in dire economic hardships that will lead to foreclosure. The goal of a deed in lieu of foreclosure is to speed up a foreclosure process and limit its damage.

They should only be used when a foreclosure is unavoidable. For example, if a homeowner knows that they will be unable to make their mortgage payments in the future, then they might want to request a deed in lieu of foreclosure.

Losing your job, racking up expensive medical bills, or experiencing a death in their immediate family are all examples of reasons why a foreclosure might be coming soon. Instead of waiting out the process and dealing with the financial consequences, a deed in lieu of foreclosure will make it easier to move on from the amount of the deficiency and rebuild financially.

Another common reason that a deed in lieu of foreclosure is sought out is when a homeowner is “underwater” with their mortgage. This is the term used to describe a situation where the principal remaining on a mortgage is higher than the overall value of the home or property. A deed in lieu of foreclosure can help prevent wasting money by paying off a loan that costs more than the property is worth.

What Is Foreclosure?

It’s important to know what a foreclosure is and why it’s so important to avoid it when possible. Foreclosure is the term for the final stage of a legal process where a mortgagor seizes a property once the loan has entered a default status due to a lack of payments.

Nearly every mortgage agreement will have a clause where the purchased home or property can be used as collateral. That means that if the mortgage isn’t being repaid according to the terms and conditions of the mortgage, the lender will legally be able to seize the property. The homeowner’s possessions will be removed from the home, and the lender will attempt to resell the property to recover their mortgage losses.

There are no fines or criminal charges brought upon the homeowner if they default on their mortgage, but that doesn’t mean there are no consequences. Besides being evicted from their home, a foreclosure will appear on the homeowner's credit report for seven years. It will be extremely difficult to get approved for another mortgage with a foreclosure on your credit report. Low credit scores will lead to higher interest rates for loans and credit cards to be approved.

What Is the Foreclosure Process?

The exact process of foreclosure varies from state to state and can be different depending on the specific terms of the mortgage. However, the process will generally look similar to this timeline:

A mortgage is considered in default after the borrower has missed a mortgage payment. Late fees will normally be charged after 10 to 15 days, and the lender will usually reach out to the borrower about making a payment.
After another payment is missed, the lender will usually increase their attempts to contact the borrower by phone or mail.
A third missed payment is when the process will speed up as a lender will send a demand letter to the borrower. They will inform them of the delinquency and give them 30 days to get their mortgage current.
Four missed payments (roughly 90 days past due) will trigger the foreclosure process specific to the state in which the borrower lives. The details are different, but the result is the homeowner is removed from the property, and the home is resold.

What Are the Different Types of Foreclosure?

There are three different types of foreclosure possible depending on the state that you live in. Foreclosures will usually take place between three to six months after the first missed mortgage payment.

The three types of foreclosures are known as judicial, statutory, and strict:

A judicial foreclosure is when the mortgage lender files a separate lawsuit through the judicial system. The borrower will receive a notice in the mail demanding payment within a set period. If the payment is not made, the lender will sell the property through an auction by the local court or sheriff’s department.
A statutory foreclosure will require a “power of sale” clause in the mortgage. After a borrower defaults on a mortgage and fails to make payments, the lender can carry out a public auction without the help of a local court or sheriff’s department. These foreclosures are typically much faster than judicial foreclosures but can’t occur within state law without very specific terms agreed upon in the mortgage agreement.
Strict foreclosure is relatively rare and only available in a few states. The lender files a lawsuit on the borrower that has defaulted and seizes control of the property if payments aren’t made within the time frame created by the court. The property goes back to the mortgage lender instead of being offered up for resale. These foreclosures are usually used when the debt amount is more than the property’s overall value.

What Is the Difference Between Foreclosure and a Deed in Lieu of Foreclosure?

A deed in lieu of foreclosure is basically a method of speeding up the foreclosure process for a reduced financial and credit penalty. A deed in lieu of foreclosure is normally a more peaceful transition of homeownership and includes several benefits for both parties. For example, a foreclosure will usually require the court systems to get involved, which will lead to legal fees for the lender. By accepting a deed in lieu of foreclosure, they will get the deed to the property back and save some money and time in the process.

For a homeowner, the foreclosure process can result in them being forcefully removed from the property by the local police department, in addition to a penalty on their credit lasting nearly twice as long. The homeowner will be required to leave home in both scenarios, but a deed in lieu of foreclosure will only impact their credit for four years and does not require a foreclosure attorney. A deed in lieu of foreclosure is definitely the better option than the seven-year waiting period during which a foreclosure will impact credit.

What Are the Pros of a Deed in Lieu of Foreclosure?

A deed in lieu of foreclosure is generally preferable to both the borrower and the lender. There are plenty of benefits for both parties involved with a defaulted mortgage, including:

Reduced credit impact – A foreclosure will remain on a credit report for seven years and usually drops the score by between 85 and 160 points. A deed in lieu of foreclosure will only stick around for four years and drop the score between 50 and 125 points.
Cheaper for the lender – The foreclosure process will require the lender to file a lawsuit and take the situation to court. A deed in lieu of foreclosure will save them the costs of going to court while still getting the deed to the property.
Less public – Quietly transferring the property's deed won’t require local courts or the sheriff’s department to get involved. Instead of public eviction, it would appear that the homeowners simply moved out of the home.

Might lower financial obligations – Depending on the state, a lender might have the ability to go after the homeowner for the difference between the original mortgage and the proceeds from the resale. A lender might be willing to waive this remaining debt in terms of a deed in lieu of foreclosure.
May get help moving. The better condition a property is in, the more valuable it is for the lender during resale. A lender might offer some help with moving in return to keep the home in good condition and grant a deed in lieu of foreclosure.

What Are the Cons of a Deed in Lieu of Foreclosure?

Although better than experiencing a foreclosure, there are still a few downsides to a deed in lieu of foreclosure. A deed in lieu of foreclosure will still result in the following consequences:

Losing the property – After an agreement is made, the name of the homeowner will be removed from the deed of the property. They will no longer be able to remain on the premises and will need to vacate within a set period of time.
No guarantees – Mortgage lenders are under no legal obligations to accept a deed in lieu of a foreclosure proposal and can deny it for any reason. Unless they find the proposal beneficial for them, they can simply deny it and continue the foreclosure process.
Damaged credit – A deed in lieu of foreclosure will damage a borrower’s credit by around 100 or so points and remain on credit reports for four years. While this is preferable to the consequences of a foreclosure, it’s not something that you should take lightly.
Tax liability – Any loan over $600 that is forgiven will be considered income by the IRS and is taxable. A deed in lieu of foreclosure may include debt forgiveness, and the borrower will be liable for the tax ramifications.
No new mortgages – A deed in lieu of foreclosure will make it extremely difficult to get a new mortgage as long as it’s on the borrower’s credit report. There is basically no difference between a traditional foreclosure and a deed in lieu of foreclosure for most mortgage lenders.
Equity loss – Mortgage lenders are under no obligation to return any existing equity in the home that might have built up over the years. They might even attempt to recover any losses after the property resale if it’s for less than the mortgage value.

Why Are Deeds in Lieu of Foreclosure Denied?

A deed in lieu transaction will typically provide several benefits for a mortgage lender, and they are inclined to accept them. However, they are under no legal obligation to even consider them and won’t accept them unless it’s beneficial for them to do so.

A lender might deny a lieu of foreclosure for the following reasons:

Property depreciation – If the property’s resale value is less than the remaining principal on the mortgage, a lender might require the borrower to pay the difference. Most deeds in lieu of foreclosure will include an agreement that the borrower is not responsible for this difference, and so a lender would potentially lose a lot of money.
Potential liens – Accepting the transfer of a deed will include all the liens and tax judgments currently levied on it. A mortgage lender might not want to accept ownership of a property where the government or another person could make a legitimate claim to own.
Poor condition – If the property is in poor condition, then a lender might not accept the offer. They would need to invest money to repair and improve the property before selling it, and it might not be worth the financial investment.

Are There Alternatives to a Deed in Lieu of Foreclosure?

Mortgage lenders won’t accept a deed in lieu of foreclosure unless it provides them with more benefits than a foreclosure would. Meeting their demands for an agreement proposal can often leave the borrower in a less than favorable position.

Before creating a deed in lieu of a foreclosure proposal, these are a few other options that can help avoid a foreclosure:

Loan Refinancing

Refinancing a mortgage is basically replacing a current mortgage with a new loan that comes with a lower interest rate. Lower interest rates on mortgages can save a lot of money in the short term and long term. It’s common for the credit scores of a homeowner to improve over time, and they might have higher scores in the present than they did in the past. A lower interest rate will make it easier to make monthly payments and pay off the mortgage faster with your monthly income.

If the homeowner owes more money than the home is worth, they can request the lender to place the difference into a forbearance account. The money placed into a forbearance account would be due whenever the mortgage is paid off, but it wouldn’t have accumulated any interest over time.

Short Sale

This tactic is most common when the property value in the area around the home has declined. A short sale will involve selling a home for less than the total remainder of the mortgage. It operates the same way as a traditional home sale, only the price is left that remains on the mortgage.

A lender would need to grant permission for sale to occur and might create their own stipulations. For example, they might request that the difference between the sale and mortgage be paid to them. It might take some time to repay the difference, but it would prevent foreclosure on the property and all the consequences that come with it.

Co-Investment

Balance Homes provides co-investment opportunities to homeowners to help them avoid foreclosure and stay in their homes while also typically saving them money each month through debt consolidation. It might sound too good to be true, but it’s pretty simple:

Balance co-invest in the property by paying off the remainder of the mortgage. This allows the homeowner to stay in the home and keep their share of equity.
The homeowner will make occupancy payments to Balance Homes every month, including operating expenses such as taxes, insurance, and HOA fees.
Balance co-owners have ongoing access to a portion of their home equity to avoid setbacks while their credit recovers. Meaning you can submit a request to access additional cash if necessary to avoid missing payments or taking on high interest debt.

Equity can be bought back at any time from Balance at pre-agreed prices. Homeowners will have the chance to refinance into a traditional mortgage and buy Balance Homes out or sell the home and keep their share of the proceeds.

The Takeaway

A deed in lieu of foreclosure is preferable to a foreclosure, but other options are available to try first.

It will take at least seven years for a foreclosure to fall off your credit report. You probably won’t get another mortgage during that time, and it might be difficult to find a place to live without the help of a housing counselor. A deed in lieu of foreclosure is much softer on your credit, but it can still come with several consequences. Before proposing a deed in lieu of a foreclosure agreement, you might want to consider alternative options.

Short selling your house or refinancing the mortgage can help you stay in your home and get back on track financially, but it will require the lender to approve either event. Like the ones offered by Balance Homes, a co-investment opportunity can help you get caught up on your mortgage and improve your finances. Get a free proposal today to see your options for a co-investment opportunity.

Sources:

Underwater Mortgage Defined | Investopedia

Foreclosure Definition | Investopedia

How Does Refinancing a Mortgage Work? | Experian

Short Sale (Real Estate) Definition | Investopedia

Q3 2021 US Foreclosure Activity Begins To See Significant Increases As Foreclosure Moratorium Is Lifted | PRNewswire.com

Deed in Lieu of Foreclosure | Investopedia

Foreclosure Process/US Department of Housing and Urban Development | HUD.gov

The 6 Phases of Foreclosure | Investopedia