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A deed in lieu of foreclosure agreement, often referred to as a "deed in lieu," is an arrangement in which a buyer who cannot keep up with their mortgage payments voluntarily turns their home over to the lender, thus avoiding the expense of a legal foreclosure proceeding.
While it's true a deed in lieu of foreclosure helps you avoid certain penalties of a legal foreclosure, the consequences remain serious. Read on to learn more about the process and whether it could be worth pursuing.
What Is a Deed In Lieu of Foreclosure?
In a deed in lieu of foreclosure arrangement, you negotiate with your lender to agree on terms for turning over your house and vacating the property in exchange for the lender closing out your mortgage loan. This spares you and the lender the legal costs of a foreclosure proceeding.
In exchange for your cooperation and leaving the house in good condition, your lender may consent to:
- Let you stay in the house for an agreed-upon length of time, so you can find other living arrangements.
- Provide a "cash-for-keys" stipend when you vacate the house—a payment you can put toward moving expenses and/or funding for a new place to live.
- Release you from some or all responsibility for deficiency on the mortgage—any amount by which the balance on the mortgage exceeds the home's appraised value.
Lenders are not obligated to grant requests for deeds in lieu of foreclosure, and can decline them for a variety of reasons (see below).
In a deed in lieu of foreclosure arrangement, your credit takes a hit, because your mortgage will be listed as closed but not paid as agreed. You also could still end up owing the lender money, and you could be liable for income tax on any portion of your debt that's forgiven, so seek legal and financial advice if you decide to go that route.
Deed in Lieu vs. Foreclosure
Foreclosure is the legal process by which a mortgage lender exercises its right to seize a house if the borrower(s) who financed the property fail to make required loan payments. Procedures differ by jurisdiction, but foreclosure can be time-consuming (taking years in some states) and expensive for both the lender and the borrower.
A deed in lieu of foreclosure arrangement, offered at the discretion of the lender, avoids the legal foreclosure process by allowing the borrower to turn the deed over to the lender voluntarily. Typically the borrower must vacate the property promptly at an agreed-upon time and leave it in good condition. In exchange for these considerations, the lender may grant the borrower certain courtesies or concessions. (More on that below.)
Pros and Cons of Deed in Lieu of Foreclosure
Here are the basic advantages and disadvantages of a deed in lieu of foreclosure:
Pros
- Lower legal costs and publicity: You avoid the legal costs of the foreclosure process and the potentially embarrassing ordeal of having notices of foreclosure published in local news outlets and posted at your home.
- Potential deficiency release: If your state allows lenders to sue borrowers to collect a mortgage deficiency—any amount by which the balance on the mortgage exceeds the home's sale price or appraised value—you may be able to negotiate full or partial release from deficiency liability as part of your deed in lieu arrangement. (Most states allow these deficiency judgments; those that don't under most circumstances are Alaska, California, Minnesota, Montana, Oregon and Washington.)
- Possible concessions that help you: As part of deed in lieu negotiations, you may be able to get permission to stay in the house for a specific interval and/or arrange for the lender to provide a "cash-for-keys" stipend payable when you vacate the property
Cons
- Your lender may refuse: Your lender is not obligated to accept a deed in lieu of foreclosure, and may reject a request for any reason. Grounds can include a large deficiency on the loan, a determination that the house is damaged or in disrepair, or the existence of one or more liens (including second mortgages) placed against the house.
- Potential tax exposure: If you negotiate full or partial release from deficiency liability, the IRS may treat the amount of the forgiven obligation as taxable income. If this is a concern, it's wise to consider talking with an attorney or tax expert about the tax tradeoffs of this approach.
- Damage to your credit: While less severe than a foreclosure, a deed in lieu of foreclosure damages your credit significantly, and can make it difficult to qualify for another mortgage for several years.
Does a Deed in Lieu of Foreclosure Hurt Your Credit?
Yes, a deed in lieu of foreclosure harms your credit, but less so than a foreclosure would. If you obtain a deed in lieu, your mortgage will be listed on your credit reports as closed with a zero balance, but not paid in full. This is a negative entry that will remain on your credit report for up to seven years.
It will tend to lower your credit scores as long as it persists, and it will likely discourage mortgage lenders from working with you for several years. (The Federal Home Loan Administration instructs issuers of federally backed mortgages to disqualify applicants with deeds in lieu of foreclosure less than four years old.)
How to Request a Deed in Lieu of Foreclosure
If you want to pursue a deed in lieu of foreclosure, here's how to go about it:
- Do your homework. A deed in lieu of foreclosure has serious consequences for your living arrangements and your credit, so before you seek one, make sure you understand its implications. Consider meeting with a housing counselor and/or a foreclosure attorney so you can explore alternatives, be sure it's your best option, and have a back-up plan in case the lender declines your request.
- Ask your lender for a loss mitigation packet. This will include forms required to obtain a deed in lieu of foreclosure, plus a list of financial documents you'll need to provide with the application. These may include pay stubs, tax returns and expense receipts that show you cannot afford to make your mortgage payments.
- Work with an expert to negotiate terms. Fill out the necessary forms and submit them, along with all required supporting documentation. It's highly advisable to have an attorney assist at this stage so they can spell out any conditions you wish to include in the arrangement, and make it clear to you what your responsibilities will be if your proposal is accepted.
- Respond as needed to follow-up communications. Promptly provide any additional documents the lender requests and address any changes or counter-proposals they make in response to your plan.
- Stick to the plan. If you reach an agreement on a deed in lieu of foreclosure arrangement, follow all provisions carefully and conscientiously to avoid breaking the contract and forfeiting the deal.
If your lender declines your request for a deed in lieu arrangement, consider other alternatives to foreclosure.
Alternative Ways to Avoid Foreclosure
In lieu of a deed in lieu, the following are other options for avoiding foreclosure:
Short Sale
A short sale typically involves a mortgage that's "upside down"—one with a balance that exceeds the home's market value. This can occur if housing prices fall after a borrower buys at a price peak, if property sustains damage that isn't covered by insurance or if home maintenance is inadequate. With the lender's permission, the house is put on the market and the lender accepts the proceeds of the sale and closes the borrower's mortgage. The loan is listed on the borrower's credit reports as not paid as agreed and, depending on negotiated terms and local laws, the borrower may be required to cover any portion of their loan not satisfied by the sale.
Mortgage Modification
A mortgage modification addresses a borrower's inability to cover their loan payments by restructuring their original loan to make monthly installments more affordable. This typically entails extending the loan term by several months or years, which adds additional payments to the loan and typically increases the total interest paid over the life of the loan.
Repayment Plan
If you've missed one or more mortgage installments but are ready and able to resume your regular payment schedule, your lender may agree to put you on a repayment plan to make up the missed payments. This may entail a lump-sum payment that covers the delinquency or an increase to your monthly payments that lasts until you've repaid the amount you missed (plus interest).
Forbearance
A temporary reduction or suspension of mortgage payments, typically for no more than 12 months, forbearance is offered as a courtesy by some mortgage lenders to customers facing short-term financial hardship. Typically limited to borrowers with good credit, forbearance is only offered to those who ask for it and provide solid evidence they'll be able to resume regular mortgage payments within a short time. You'll also need to show that you can cover the cost of—and enter a repayment plan to catch up on any payments that weren't made during forbearance.
Chapter 13 Bankruptcy
This legal process addresses overwhelming debt by setting up a repayment plan to repay your creditors fully or in part. If your income supports it, Chapter 13 can allow you to catch up on late mortgage payments and maintain house payments while eventually erasing many other forms of consumer debt. Chapter 13 is even more severely negative for your credit than foreclosure. It remains on your credit report for seven years and causes deep, lasting damage to your credit scores.
The Bottom Line
Seeking a deed in lieu of foreclosure requires accepting the painful reality that the loss of your house and a hit to your credit are inevitable. If you're facing that situation, a deed in lieu could be your best option for cutting legal costs and moving on within a span of a few years. When you're ready to seek another mortgage, check your FICO® Score☉ for free from Experian to know where you stand and, if necessary, take steps to build up your credit before you begin shopping for another home.
