Deeds in Lieu of Foreclosure

A common misconception among the home owning population is that lenders are eager to repossess their homes when they default on their mortgage loan payments.  They imagine the lender to be a Simon LeGree character demanding that they “pay the rent or else!”  To forestall the foreclosure process and to “preserve their credit”, some defaulting borrowers try to give their property back to the Lender voluntarily.  In return, they believe the lender will consider the borrower’s loan paid in full.  Contrary to this opinion, lenders are quite reluctant to receive property back.  The last thing they want to do is become property owners.  They are in the business of loaning money, not managing real estate.  In addition, there are many regulatory and economic reasons a lender dislikes receiving property back.  Nonetheless, there are some rare times when giving the property to the lender does make sense.  The remainder of this article describes this “Deed in Lieu of Foreclosure” process in more detail.

Many homeowners finance the purchase of their homes using a Promissory Note secured by a Deed of Trust.  If they fail to make the payments required by the Note, the lender will use the Deed of Trust to foreclose their interest in their loan.  The lender will then sell the home at an auction, and use the sale proceeds to pay off the borrower’s loan.  The ordinary process of foreclosure takes approximately six months and is governed under the Deed of Trust Act.  What the Deed in Lieu of Foreclosure process does is to allow the borrower to voluntarily give the property back before formal foreclosure is initiated.  This process is used when the borrower is in serious default and the property is worth more than the amount of the loan.  This process saves the lender the time and expense of formally foreclosing on the property.  The lender, upon the surrender of the property, usually considers all outstanding debts on the property paid for in full.  Economically, this process saves both parties time and trouble, so it is a viable and efficient option to explore.

However, there are some serious points to consider before requesting that your lender accept a Deed in Lieu of foreclosure.  Most lenders are just as unwilling to do a Deed in Lieu as they are to foreclose.  This is because the lender becomes the owner of the property.  They do not want to become property managers as well as lenders.  The property becomes a drain on the lender’s finances, and reflects poorly on their asset-to-debt ratios.

It is entirely within the lender’s discretion as to whether they accept the property back in lieu of foreclosing on it.  According to the Deed of Trust Act, the lender cannot force the borrower to give up the property before the Act allows.  Conversely, the borrower cannot force the lender to accept the property in lieu of foreclosure.  The borrower must convince the lender that it is to their financial advantage or truly a last resort remedy.  Needless to say, this is often a tough sell for the borrower.

Another caveat is the damage to one’s credit report that will occur.  Many borrowers think that the Deed in Lieu of Foreclosure is a “cure all” for their financial difficulties, and will not harm their credit rating as much as a formal foreclosure.  Borrowers should be aware that, to a future lender, a Deed in Lieu of Foreclosure on their record often looks just as bad as a foreclosure.  This means that, credit rating wise, the Deed in Lieu of Foreclosure may not hold much advantage for the borrower.

There are times when a Deed in Lieu of Foreclosure is an avenue that should be pursued.  When a borrower is financially destitute and the only option available to them is to wait for the lender to foreclose, they should try to negotiate a Deed in Lieu with the lender.  Often, a lender will require that the borrower have substantial equity in the property before they will agree to this transaction.  This will help the lender to recoup some of its losses.  The borrower should also keep in mind that the Mortgage Insurance Company must also agree to the transaction.  They are the ones who will reimburse the lender for its losses.  This makes for a complicated negotiating process, since there are multiple parties who must ratify the deal.  Assuming all parties are in agreement, then the borrower can give he property back.  The primary benefit to the borrower is emotional: they no longer have to worry about having a lender hound them regularly for their debt; they do not have to worry about seeing their names published in the newspaper under the Legal Notices Column; and they have the satisfaction of knowing they did right by their lender.

In summary, the Deed in Lieu of Foreclosure can appear to be a golden fleece: full of false hope and promise without much likelihood of being attained.  It is a process that should be reserved for those who face foreclosure, without any other options available to them.  For them, the slight advantage that a Deed in Lieu of Foreclosure offers may be worth it.

Published October 1997

This article contains information of general interest, and is not intended to be, nor should it be relied upon as a substitute for specific legal advice.