Loss Mitigation: Foreclosure vs. Short Sale vs. Deed-In-Lieu
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Mortgage companies are well aware of the unfortunate circumstances that could cause a borrower to fall behind on their monthly loan payments. As a foreclosure is a very costly process for the lender, and not to mention its negative financial impact on the borrower, this is where loss mitigation comes in to benefit both the lender and the borrower.
The term loss mitigation refers to a loan servicer's responsibility to help mitigate or lessen the loss to the loan owner, resulting from the borrower's default on their mortgage.
Disclaimer – The information on this page is intended for general informational purposes only and not to provide legal advice.
Loss mitigation options include those that allow the borrower to stay in the home —such as a loan modification. Then there are other options, like a short sale or deed in lieu of foreclosure, in which the borrower gives up the property, but without having to go through a foreclosure.
Under federal mortgage servicing laws, in most cases, if a mortgage payment is 45 days' delinquent, the servicer must assign personnel to work directly with the borrower on loss mitigation. The staff member or team assigned must be readily available by phone to the borrower to advise them on:
- loss mitigation programs available
- how to submit a loss mitigation application
- the current status of a submitted loss mitigation application
- how to appeal a denied request
- when and why the account may be referred for foreclosure
What is a foreclosure?
Before discussing loss mitigation, we must first cover what a foreclosure is and what it entails, as loss mitigation is designed to avoid foreclosure.
When a homeowner fails to make their mortgage payments, this can result in foreclosure. This is a legal process in which the mortgage lender or bank reclaims a home when the loan reaches delinquent status.
Although the loan is considered delinquent on the first day of a missed payment, under federal law, the lender must wait until the homeowner is more than 120 days delinquent on payments before making the first official notice or filing for foreclosure.
If no action is taken by the homeowner to stop the foreclosure process – such as bringing their payments current (and then possibly lowering their monthly payments) or applying for loss mitigation programs, the lender will reclaim the home and sell it to recoup the unpaid balance owed on the loan.
The foreclosure process includes the following steps:
1. Notice of Default and Intent to Accelerate:
This is the official foreclosure notice sent by the bank to the homeowner, required by Texas law, which provides a minimum 20 day grace period for the owner to make their late mortgage payments. Once this notice is sent, the home is considered to be in pre-foreclosure.
2. Notice of Sale:
If the homeowner doesn't pay their debt within the grace period, the lender then sends a notice of sale, which arrives at least 21 days before the foreclosure sale is scheduled. The notice is also posted on the county courthouse door and filed with the county clerk, including the date, time, and location of the sale.
3. The Foreclosure Sale:
Held on the first Tuesday of each month at the county courthouse, the property is sold to the highest bidder. The lender may also bid for the home, and if they are the highest bidder, ownership will revert to the bank, and the property will be considered Real Estate Owned (REO).
4. Deficiency Judgement:
In some cases, the homeowner may still owe the lender money after the foreclosure, if the home sells for less than the amount owed on the loan. In this case, the lender may file a lawsuit to recover the difference. In Texas, the bank has up to two years to sue the nonjudicially-foreclosed owner, but if it forgoes or loses the suit, it will not be entitled to collect the remaining balance.
In Texas, there are two different types of foreclosure procedures – nonjudicial and judicial foreclosures.
The majority of Texas foreclosures are nonjudicial, meaning that the lender does not need to go through the court system. This is made possible by a power of sale clause included in the deed of trust or mortgage agreement at the time of purchase, which pre-authorizes the sale of the property by way of a nonjudicial foreclosure to pay off the balance of the loan in the event of a default. The borrower may file a lawsuit to seek judicial review of the case but is responsible for all legal fees incurred.
A judicial foreclosure requires the lender to go through the state court and obtain approval before foreclosing on a property. This type of foreclosure is permitted in all 50 states, but not required in Texas.
With this type of foreclosure, the lender files a lawsuit requesting the right to sell the home and apply the sale proceeds to the debt. The lender may also request a deficiency judgment during this stage. The homeowner is then served a court summons and allowed to respond to the complaint before the court. If the court rules in favor of the lender, foreclosure proceedings continue with the sale of the home.
Keep reading below to learn about the different types of loss mitigation programs and what are the advantages and disadvantages of each one.
What is a short sale?
A short sale is a loss mitigation option available to homeowners going through financial distress which causes them to get behind on their mortgage payments, and the home becomes worth less than the outstanding balance owed on the mortgage. In this case, they may be able to agree to a short sale instead of a foreclosure.
Short sales are usually initiated by the homeowner when the value of a home drops by 20% or more, and the mortgage lender must first sign off on the decision to move forward with a short sale.
If a short sale is approved, the buyer negotiates the home sale price with the homeowner first, and then the lender, usually the bank who owns the mortgage, needs to approve it. Short sales can take up to a year to process, and there's a lot of intensive paperwork involved.
The home selling process with a short-sale property is very similar to a regular home purchase. The only difference is that the contract specifies that the terms are subject to the mortgage lender's approval, as it's the bank that will receive the proceeds from the sale, not the seller. Even though the bank doesn't own the property – as it does with a foreclosure – the buyer will be still dealing mostly with the bank instead of the homeowner directly.
What is a deed in lieu of foreclosure?
Homeowners who have defaulted on their mortgage payments, and have been denied a loan modification or short sale by their lender, may choose a deed in lieu of foreclosure when their mortgage is underwater and they don't have any equity in the home.
A deed in lieu of foreclosure is a document that transfers the home title from the homeowner to the bank that holds the mortgage. It's signed by the homeowner, notarized by a notary public and then recorded to public record.
Typically, lenders will only approve a deed in lieu of foreclosure if there aren't any other existing liens on the property. A lender may require that that the owner tries to sell the home before it considers accepting a deed in lieu, and require a copy of the listing agreement as proof that this action has been taken.
If a deed in lieu is approved, the homeowner has to relinquish the property and relocate. However, they are usually relieved from owing the remaining balance on the loan.
To avoid a deficiency judgment, which is the difference between the home's fair market value and total debt which the lender may sue the borrower for, the deed in lieu agreement must expressly state that the transaction fully satisfies the loan debt. If the deed in lieu agreement does not contain this provision, the lender might file a lawsuit to obtain a deficiency judgment.
Other advantages of a deed in lieu to both the lender and the borrower include avoiding time-consuming and costly foreclosure proceedings, and the owner can keep their situation more private, as a deed in lieu is handled with less public visibility than a foreclosure. In some cases, the property owner may be able to reach an agreement with the lender that allows them to lease the property back from the lender for a mutually agreed upon period.
What happens to liens and second mortgages in a foreclosure?
Property liens are established in order of priority, which is usually based on its recording date. Although some liens, like property tax liens, have superiority against any prior lien. As first mortgages are typically recorded first, it's in the first lien position. Second mortgages, which are often recorded next, are usually second in line. Judgment liens are usually considered junior to a first and second mortgage.
In a foreclosure, senior liens (those with higher priority) are paid first, before junior liens (those with lower priority). If there are any surplus funds from the foreclosure sale after the foreclosing lender's debt has been paid off, it will be dispersed to those creditors holding junior liens, like a second mortgage lender or judgment creditor (for instance, if someone sued you in court and won a monetary judgment).
How is a short sale affected by liens and second mortgages?
To obtain a clear title following a short sale, the first mortgage lender must attain releases from all junior lienholders. If there's a second mortgage, home equity loan, or judgment lien on the property, all parties must sign off on the short sale deal, not just the first mortgage lender. To get the junior lienholders to agree, the first mortgage holder will offer each junior lienholder a portion of the debt they are owed, to release their lien.
Problems can arise when the junior lien holders are seeking more money than the first lender is offering. This can make it very difficult to get their approval for a short sale. Potential solutions to this include convincing the junior lienholders that they'll receive more money through a short sale than they would in foreclosure, or convincing the first lender to apply more of its share to the junior lienholders.
What happens to junior liens with a deed in lieu of foreclosure?
A deed in lieu will not get rid of any junior liens on the property. When such liens exist, the lender will become liable for them if a deed in lieu is accepted. In those cases, a lender is more likely to pursue foreclosure instead of a deed in lieu, where the liens would be paid in order of their priority.
What are the tax implications for short sales and a deed in lieu?
If your lender agrees to a short sale or to accept a deed in lieu, you may be responsible for paying income tax on any resulting deficiency. In a short sale, the deficiency would be in cash, and with a deed in lieu, it would be in equity.
The IRS becomes aware of the deficiency when the lender sends an IRS Form 1099C, which reports the forgiven debt as income to you.
Tax laws spell out specific circumstances when you may be exempt from paying tax on canceled debts. These are called exclusions, meaning that the amount is excluded from your taxable income. There are currently three exclusions which apply to canceled mortgages.
- Debt canceled in a bankruptcy
- Debt canceled when the person is insolvent (when total debts are greater than the value of total assets)
- Debt that qualifies under the Mortgage Forgiveness Debt Relief Act
Each of these exclusions has its own set of criteria and reporting procedures. Also, if you are going to file for bankruptcy, then there is no point in doing a short sale or deed in lieu, because any benefit to your credit rating, would be wiped out by bankruptcy.
What are the differences in how your credit is affected with a foreclosure vs. short sale vs. deed in lieu of foreclosure?
According to FICO, the higher your credit score is at the time of foreclosure, the more it will drop as a result, and you can expect to fall on average between 80–160 points.
A foreclosure will remain on your credit report for seven years, with your score gradually increasing, but it won't be fully recovered until it's dropped from your record.
In general, you will probably need to wait seven years after a foreclosure to get a conventional mortgage, three years to get an FHA or USDA loan, and two years to get a VA loan. You may be able to shorten this waiting period by making a sizeable down payment or paying a higher interest rate.
With a short sale, it will also stay on your credit report for seven years listed as a “negotiated settlement.” However, the negative impact will diminish with each year that passes, as recent credit actions have a more considerable effect on your credit score than past events. If you work on rebuilding your credit following a short sale, you may be eligible to purchase a new home in as little as two years.
A deed in lieu is not as damaging as a foreclosure to your credit report, especially if there is no deficiency balance. It will stay on your credit report for up to seven years, but you may be able to buy a new home within two to three years.
How can AMI help if you were denied a loss mitigation option such as a short sale or deed in lieu, and you are now facing foreclosure?
If your lender has rejected your request for a short sale or deed in lieu, or these loss mitigation programs are not right for you, and it looks like foreclosure is your only option, this is where AMI can help.
We can make you a cash offer on your property and cover all the closing costs for the Buyer (us) and Seller (you). This would allow you to sell your home quickly while avoiding the implications that result from foreclosure or loss mitigation programs.
Simply fill out this form to receive a no-obligation cash offer, regardless of what condition it's in or what situation you are currently facing. If you accept our offer, we can close in 10 days or less.