A deed in lieu of foreclosure is a tool homeowners hope they never have to use. Nonetheless, it’s a tool that—when used correctly—can save distressed homeowners years of financial hardships and headaches. Unfortunately, however, far too many homeowners aren’t familiar with this particular arrangement or even what it can do for them. In reality, it’s a safety net, which begs the question: What is a deed in lieu of foreclosure? Below we will go into what this self-preservation strategy is and who is better off using it.
What Is Deed In Lieu Of Foreclosure?
A deed in lieu of foreclosure is essentially an arrangement proposed on behalf of distressed homeowners to their mortgage underwriters to avoid foreclosure. As the name suggests, a deed in lieu of foreclosure arrangement will require the distressed homeowner to transfer the property’s title to the lender. In return, the lender will forgive the distressed homeowner of their mortgage debt.
Provided an arrangement can be reached, the lender will assume the property title, and the distressed homeowner will avoid foreclosure. However, it is worth noting that the homeowner’s credit report will reflect the deed in lieu of foreclosure form. While not as damaging as a foreclosure, a deed in lieu of foreclosure will negatively impact one’s credit history.
Will A Lender Reject A Deed In Lieu?
To be clear, a deed in lieu of foreclosure is typically regarded as a last-ditch effort on each party’s behalf. For the most part, lenders will want to avoid following through with a deed in lieu of foreclosure agreement for any number of reasons, not the least of which include:
Depreciation: Underwater homeowners who owe more on the loan than the property is worth are at an increased risk of their deed in lieu of foreclosure arrangements being rejected. If, for example, the difference between the appraised value and the remaining balance on the mortgage isn’t worthwhile for the bank to forgive, the lender may turn down any request to do so. That said, some lenders will allow distressed homeowners to pay the difference first and then enter into an agreement only after the difference is paid. When all is said and done, the arrangement must be worthwhile for the lender.
Prohibitive Liens & Tax Judgements: In the event the home has an existing lien that supersedes the lender’s ability to reclaim the property, a deed in lieu of foreclosure is almost guaranteed to be turned down. If for nothing else, the lender will assume the responsibility of the lien, which is rarely worth their time or money. If, however, the owner can settle the lien before making the arrangement, they may be able to pull the deal off.
Obvious Financial Concerns: If the home is in obvious need of repair or there are glaring financial needs, the bank is likely to turn down any request for an arrangement where they forgive the debt. Any need to put money into the property then becomes the bank’s responsibility once they take ownership.
Financial Incentive: No bank will accept a deed in lieu of foreclosure arrangement if there’s no financial incentive to do so. That said, there are many reasons the bank may actually want the homeowner to go into foreclosure. It is not uncommon for some government-backed loans to only pay the lender out if the home is actually foreclosed on. Therefore, it’s in the best interest of the bank to actually foreclose on the home.
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Will A Lender Accept A Deed In Lieu?
Again, it’s never in a lender’s best interests to agree to a deed in lieu of foreclosure arrangement. Perhaps even more importantly, there’s nothing that says a lender even has to agree to such an arrangement. Most lenders would be perfectly content with letting the homeowner fall into foreclosure and repossessing the home. However, some circumstances may force a lender to accept a deed in lieu of foreclosure arrangement:
Saves Time & Money: Lenders would prefer it if borrowers lived up to their mortgage obligations. Monthly installment payments are the surest way to profitability for banks. If the borrower is no longer able to maintain their obligations, the impending foreclosure threatens to eat into the lender’s profits. In addition to losing out on principal payments, the lender will need to do everything from hiring attorneys to following through with an eviction, all of which cost additional time and money. As a result, some lenders will accept a deed in lieu of foreclosure proposal if it saves them more money and time than the foreclosure process will require.
Appreciation: Lenders are much more likely to agree to a deed in lieu of foreclosure arrangement if the subject property has appreciated in value. Homes in good condition, which have appreciated in value, will sell for more money once repossessed, which makes them attractive to lenders.
Pros Of A Deed in Lieu Of Foreclosure
While homeowners would ultimately want to avoid having to get to the point where they exercise a deed in lieu of foreclosure agreement, there are several advantages worth considering:
May Help Underwater Homeowners: The phrase underwater homeowner describes someone who owes more on their mortgage than the home is actually worth. Subsequently, underwater homeowners inherently have a negative difference between their mortgage balance and what the home is worth. Otherwise known as a deficiency, the negative difference can be eliminated by a deed in lieu of foreclosure agreement. For the lender to forgive the deficiency, however, the distressed homeowner must relinquish the deed voluntarily.
Cash For Keys: While it may be considered a small consolation prize, distressed homeowners may be able to receive moving assistance when they execute a deed in lieu of foreclosure agreement. If for nothing else, any lender who agrees to take over the title in exchange for forgiving the debt will want the property as soon as possible. To do so, however, the homeowner will need to move. While not always the case, the lender may offer to provide moving assistance. The assistance could take the form of a “cash for keys” agreement, which literally pays the homeowner money to get them out faster. The immediate removal of the occupant may be worth the money for the bank if they can put the property in operation sooner rather than later.
Mitigate Credit Damage: It should be noted that while a deed in lieu of foreclosure agreement tends to stick to its promise, distressed homeowners are still penalized. While the homeowner will avoid the serious financial ramifications of a foreclosure, a deed in lieu of foreclosure agreement is not without consequence. Instead of a foreclosure remaining on the record, deed in lieu agreement will stay on a homeowner’s credit report for 4 years (three less than a foreclosure).
Cons Of A Deed in Lieu Of Foreclosure
Despite awarding distressed homeowners out of precarious financial situations, deed in lieu of foreclosure arrangements aren’t without their drawbacks. In fact, there are several significant ramifications homeowners need to consider:
Loss Of Property: In exchange for forgiveness of the debt, the distressed homeowner must hand over the title of their property. There are no exceptions in this scenario, which is why deed in lieu of foreclosure agreements should be viewed as a final option.
No Promises: Lenders and banks are never obligated to accept the arrangement. More often than not, in fact, banks will decline the proposal. Consequently, the only time they will consider a deed in lieu of foreclosure agreement is when it is to their benefit and not the owner’s.
Damaged Credit: Arranging this type of agreement with a bank will prevent foreclosure, which significantly damages one’s credit. That said, a deed in lieu of foreclosure agreement still damages credit, just not as bad as a foreclosure would. Instead of staying on your credit history for seven years (like a foreclosure), an arrangement will only hurt your credit for four years.
Negative Tax Implications: If an agreement is accepted and the lender chooses to forgive more than $600 in loan deficiencies, the IRS will view the forgiven funds as income. As a result, the homeowner will be expected to pay income tax on the deficient funds.
Alternatives To Filing For Foreclosure
It is often in the best interest of a homeowner to avoid foreclosure. In addition to losing the home and suffering a significant financial setback, the process is strenuous and heartbreaking. However, it is worth noting that there are multiple opportunities that award homeowners alternatives to filing for foreclosure. In addition to a deed in lieu of foreclosure agreement, distressed homeowners may turn to loan modifications and short sales.
As the name suggests, a loan modification is when the lender changes the original terms of the loan to help the distressed homeowner. Of course, the lender is by no means required to do so, but it’s often preferred over the alternative foreclosure. If a lender can modify a loan and keep the borrower in the home while paying their balance each month, they will most likely choose to do so. Modifications may include anything from lower interest rates to deferring interest on excess principal on underwater homes. Regardless of the modification, both the borrower and lender will most likely prefer a slight modification over a foreclosure.
Outside of loan modifications, distressed homeowners may conduct a short sale. Provided the lender approves the short sale, the owner will sell the home for less than the amount owed on the mortgage. The proceeds will go to the lender, but the owner will avoid foreclosure.
A deed in lieu of foreclosure is exactly what it sounds like: an arrangement between distressed homeowners and their lenders that forgives unsettled funds in exchange for the title of the property. As such, both parties view this particular arrangement as a last-ditch effort of self-preservation. Lenders, on the one hand, gain another chance to recoup lost earnings. Distressed homeowners, on the other hand, avoid foreclosure. Nonetheless, it goes without saying that a deed in lieu of foreclosure agreement is a strategy that should be reserved for when every other option is exhausted.
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