Most people know that for a homeowner who owes more on their home than the home is worth can sell it short. This is commonly known as a ‘short sale’.  Often time homeowners try to modify their loans but if both of these options fail then the homeowner will eventually have it end in foreclosure?   What most people don’t know is that there is a third alternative.  It is called a ‘Deed In Lieu of Foreclosure’.  A Deed in lieu of foreclosure is a deed instrument in which a mortgagor (i.e. the borrower) conveys all interest in a real property to the mortgagee (i.e. the lender) to satisfy a loan that is in default and avoid foreclosure proceedings.

I receive calls all the time from home owners who are interested in whether they should consider a Deed in Lieu of foreclosure or a short sale on their property. Usually the owner is interested about the Deed in Lieu when they are unable to meet their financial obligations on the home and there is no equity left in the property.  A Deed in Lieu may be submitted by the borrower after talking to the lender about this as an alternative to paying off their mortgage but sometimes the borrower will submit the Deed in Lieu without lender agreement.  The lender can show their refusal of the Deed in Lieu by filing a Notice of Non-Acceptance with the County Recorders Office.

So, after asking a few questions I find out that they owe, for example, $700K on their 1^st mortgage, $75K on their 2^nd mortgage and the home would probably only sell for $600K.

When the 1^st lender on a property agrees to do a Deed in Lieu, they are basically taking over ownership of that property including all liens on the property.  You have to ask yourself “What is the lenders’ motivation to take this Deed vs. accepting a short sale or just foreclosing on the property?”

If the lender agreed to do a Deed in Lieu they would turn around and sell the home as banks don’t want to be in the home ownership business. The lender will probably want to obtain a Preliminary Title Report to check for other liens on the property as these liens will remain after the Deed is transferred to the lender.  Accepting the Deed in Lieu may leave the lender accepting the Deed with even less money if there are existing junior liens.

In the example above, the lender may possibly have to pay the 2^nd lender the entire $75,000 in order to sell the property. They would be upside down on their own loan by $100,000 and would incur some costs (assume $70,000 which is a little high) in closing the transaction. So, accepting the Deed in Lieu could cost the lender $245,000 as there is no equity in this home.  The bank doesn’t have much incentive in this case to do the Deed in Lieu.  Banks will more often consider doing the Deed in Lieu when there is only one lien that is theirs and they don’t have to take on junior liens.

On the other hand, if the 1^st lender agreed to do a short sale they would try to get the 2^nd lender to settle for pennies on the dollar…..maybe between $2,000 and $7,500.  They would be upside down on their own loan by $100,000 and would incur some costs in closing the short sale transaction (again, assume $70,000).  So, they would only be upside down by around $177,500 accepting a short sale vs. $245,000 as in the example for the Deed in Lieu.  This would appear to be a better alternative for the lender.

In a foreclosure, the liens junior to the foreclosing Deed holder can be wiped out if the foreclosure sale comes up short.  Therefore, this lender would have more incentive to do a foreclosure vs. a Deed in Lieu.  Each situation is different so it’s important to consult a real estate professional for more information.