What Is Voluntary Foreclosure?

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A voluntary foreclosure is one that's initiated by a borrower when they are unable or unwilling to make the mortgage payments on their home. When this happens, the lender takes possession of the property. If your mortgage is underwater, meaning the principal amount you owe on the home is more than the fair market value, this might be an option to prevent involuntary foreclosure and eviction.

What Is Voluntary Foreclosure?

A voluntary foreclosure lets you leave the property on your own terms within an agreed upon time frame. In exchange for releasing you from making future payments, ownership of your home is transferred to the lender. Voluntary foreclosure differs from involuntary foreclosure, which is a process the lender starts in order to recover their losses when you default on your loan.

During the subprime mortgage crisis in the late 2000s, some lenders started approving mortgages for borrowers who had lower credit and were considered less likely to meet their repayment obligations. They offered these consumers risky subprime loans with high interest rates that many borrowers could not repay. This was one factor that led to an uptick in voluntary foreclosures.

Prior to the mortgage crisis, voluntary foreclosures—also called friendly foreclosure, mortgage release, strategic release or simply walking away—were rarely used. But with a shifting real estate market and challenging economic times, some homeowners still may choose this option today.

Used for most voluntary foreclosures, a deed in lieu of foreclosure releases the borrower from making future payments on their mortgage by transferring ownership of the property to the lender. It can keep both lenders and homeowners from dealing with a costly and time-consuming standard foreclosure. Even so, facing foreclosure of any kind can be stressful, so before choosing voluntary foreclosure as an option, weigh the pros and cons first.

Pros and Cons of Voluntary Foreclosure

If you're considering a voluntary foreclosure, look over the advantages and disadvantages before making this all-important decision.

Pros

  • Cut your losses: Leaving on your own terms can have less social stigma than being forcibly evicted—although neither is pleasant. It can also give you time to make plans for the future and relieve some of the pressure of the foreclosure process.
  • Stop payments sooner: Voluntary foreclosure gives you the option to stop making mortgage payments. This can be a big advantage if your mortgage is underwater or you've lost your source of income.
  • Faster process: When compared with a standard or involuntary foreclosure, the voluntary foreclosure process can be much faster (and easier) for both you and the lender.
  • Less credit impact: Although any type of foreclosure impacts your credit, a voluntary foreclosure may affect your credit to a lesser degree. That's due to the use of a deed in lieu of foreclosure. An involuntary foreclosure can impact your credit for seven years. With a deed in lieu of foreclosure, your credit may only be impacted for four years.

Cons

  • Deficiency judgment: A deficiency judgment is a court ruling that requires you to cover the debt in full if you default on a loan that's secured by your home. With a voluntary foreclosure, you may be liable to pay 100% of the difference between the value of your home and the remaining balance on your mortgage.
  • Finding a new home: Because you leave your current home, you'll need to find a new one. However, some landlords may be reluctant to rent to you, and you most likely won't be able to qualify for a new mortgage. For example, Fannie Mae requires a four-year waiting period before you're eligible for a new mortgage after a deed in lieu of foreclosure.
  • Tax implications: The IRS considers a canceled debt as taxable income. With a voluntary foreclosure, your debt may be forgiven but you may still incur taxes, which can be costly.
  • Impact on credit: Although the impact on your credit may be less than with an involuntary foreclosure, your credit will still take a major hit. This can make it much more difficult to qualify for credit in the future, and if you do qualify, the interest rates will likely be significantly higher.

Alternatives to Voluntary Foreclosure

If you are considering a voluntary foreclosure, take a look at several alternatives first. They may have less impact on your credit, finances and life than a foreclosure will have.

Mortgage Forbearance

Your lender may be willing to work with you to provide mortgage forbearance, a temporary suspension or reduction in your payments. You may qualify if you've experienced a recent increase in your living expenses or a reduction in your income. But, you must demonstrate that you can make the new payments and meet the requirements of the new repayment plan.

Mortgage Loan Modification

If you had a temporary financial setback, your lender might be willing to work with you to modify the terms of your mortgage. For example, your lender might extend the length of time you have to pay off your mortgage, which can often lower your monthly payments. However, lengthening your term can mean you pay more in interest over time.

Short Sale

A short sale agreement means your lender is willing to accept less than the mortgage amount you currently owe. Sometimes the difference is forgiven by the bank or lender, or you may have to make arrangements to pay off the remainder of your mortgage debt upon the sale of your home. Short sales are typically done to avoid foreclosure on the home.

Partial-Claim Loan

Some government-backed loan programs, like those supported by the Federal Housing Administration (FHA), may allow you to receive a small loan to apply to your mortgage balance. However, keep in mind that in addition to paying off your mortgage, you'll also be required to pay back the loan.

The Bottom Line

Foreclosure doesn't only affect your physical and mental health but also your financial health. Sometimes, however, it can't be avoided, so it's important to consider steps to lessen the blow. If your home has lost market value and may continue to do so in the foreseeable future, a voluntary foreclosure may be an option. And a voluntary foreclosure does less damage to your credit than an involuntary foreclosure.

Even so, If you experience a foreclosure, your best bet is to take steps as soon as possible to start rebuilding your credit. Keep an eye on your progress by checking your credit report and score with Experian's free credit monitoring. With time and patience, and a little hard work, you can bounce back and start anew after a foreclosure.