Effects of a Deed in Lieu of Foreclosure on Credit

Definition

A deed in lieu of foreclosure occurs when your mortgage company agrees to take back the house and relieve you of your financial obligation in exchange. The basic concept is that you are handing your asset to the bank, instead of having the bank foreclose on your house, and thus having the debt erased. It sounds reasonable, but if you owe more on the property than what it's worth, your lender may not have much to gain. With a deed in lieu of foreclosure, the bank agrees not to hold you responsible for paying the difference between the mortgage balance and the value of the property. Therefore, not every lending institution is willing to accept this type of offer.

Advantages

A deed in lieu of foreclosure is a less public event than a standard foreclosure, so you may be able to move without your neighbors realizing that you are having financial challenges. If your lender agrees to the deed in lieu of foreclosure agreement before 2012, the Mortgage Debt Forgiveness Tax Relief Act may relieve you of your obligation to pay income tax on any amount of your loan that is forgiven by the bank. If you are not behind on your payments, you may be able to negotiate with your bank with a more ambitious posture. Lenders consider these arrangements because they are less expensive than a foreclosure and can be completed in less time.

Credit Impact

The effect of a deed in lieu of foreclosure on your credit will be negative. Sometime the reduction in your credit score can be as much as what would be caused by a foreclosure, if your lender reports it as such. If your score has been suffering for many months as a result of late or missed payments for a variety of bills, the damage to your score won't be as significant as for someone whose credit rating still is good. According to the Fair Isaac Corporation, which developed the FICO credit scoring model, your payment history accounts for 35 percent of your score. The CNN Money website reports that the Fair Isaac Corporation estimates you can expect a drop of 85 to 160 points in your credit score from a deed in lieu of foreclosure, depending on what your score was before the transaction occurred.

Considerations

You should write to your lender as soon as you realize you cannot pay your mortgage and that your situation will not be improving in the near future. A letter is better documentation than a telephone call, and your lender is more likely to consider your formal request because it won't appear that you were forced into forfeiting your property. If you wait too long, the default, collections and foreclosure process will begin whether you agree to the deed in lieu of foreclosure or not. If your mortgage company accepts your offer and proceeds with a deed in lieu of foreclosure, ask that it be reported to the credit bureaus as "Paid as Agreed," instead of "Paid as Settled" or "Foreclosure." This will give you an opportunity to apply for another mortgage when you can afford a home again.