Avoiding foreclosure with a short sale or deed in lieu of foreclosure.

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If you can’t afford your mortgage payments and are ready to give up your home, then you might be able to avoid a foreclosure, and perhaps a deficiency judgment, with a short sale or deed in lieu of foreclosure. In addition to potentially preventing a deficiency judgment, another upside to completing either of these options is that you won’t have a foreclosure as part of your credit history.

But your credit scores will still take a major hit. A short sale or deed in lieu of foreclosure is almost as bad as a foreclosure when it comes to your credit. For some people, however, not having the stigma of a foreclosure on their record is worth the effort of working out one of these alternatives.

Another upside is that some banks offer relocation assistance, often a thousand dollars or more, to help homeowners find new housing after a short sale or deed in lieu of foreclosure.

Generally, a bank will agree to let a homeowner off the hook for a deficiency with a deed in lieu of foreclosure-but not always.

Short Sales: Sell Your Home for Less Than You Owe
Deed in Lieu of Foreclosure: Give Your Home to the Bank
Avoiding a Deficiency Judgment
Getting Help
Short Sales: Sell Your Home for Less Than You Owe

A "short sale" is when a bank agrees to let the homeowners sell their home to a new owner for less than the total mortgage debt. If your mortgage is "underwater" (meaning you owe more on the loan than your home is worth), then a short sale might be a good way for you to avoid a foreclosure. (If you have equity in your home, on the other hand, you can sell it to a new owner and pay off the bank in full.)

How to Apply for a Short Sale

To do a short sale, you must submit a loss mitigation application to your mortgage servicer. The application is usually in the form of a "Request for Mortgage Assistance" (RMA) questionnaire. You’ll also probably have to provide supporting documentation like pay stubs and bank statements.

Sometimes, a bank requires a homeowner to have an offer from a potential purchaser when submitting a short sale application, but not in all cases. If you want to complete a short sale, contact your mortgage servicer to find out if your bank requires a purchase offer along with an application.

Deficiency Judgments After Short Sales

In a short sale, the difference between the total mortgage debt and the sale price is the "deficiency." With a short sale, the bank might waive (give up) its right to all or part of the deficiency. (However, if the lender forgives the deficiency, you might face tax consequences.)

But if the bank doesn't waive the deficiency as part of the short sale, state law generally allows it to file a lawsuit afterward to get a personal judgment, called a "deficiency judgment," against the homeowner.

Example. Suppose Mr. and Mrs. Smith purchased a new house in 2017 for $300,000. At that time, Mr. Smith was a stay-at-home dad, and Mrs. Smith worked in advertising. A few years later, Mrs. Smith lost her job, and the couple couldn't make the mortgage payments anymore. Because the house was worth only $275,000, and the Smiths still owed the bank $300,000, the Smiths asked for permission to sell the property for $275,000. The bank approved the short sale but didn't waive the deficiency, and the home was sold to a new owner. A few months after the sale, the bank filed a lawsuit in court against the Smiths and got a deficiency judgment in the amount of $25,000.

A bank can then usually, depending on state law, collect a deficiency judgment by taking money from the debtor’s bank account or garnishing the debtor’s wages.

If your bank won't agree to waive the deficiency and you're still considering a short sale, make sure that your state doesn't have a law prohibiting deficiency judgments following foreclosures. If you won't face a deficiency judgment after a foreclosure (but you might after a short sale), it might make sense to let the foreclosure go through and get more time to live in the home.

Under California law, a bank can’t get a deficiency judgment after a homeowner completes a short sale of a residential property that has no more than four units. Check with a lawyer to find out if your state has a similar law, though not many do.

Deed in Lieu of Foreclosure: Give Your Home to the Bank

Another way to avoid a foreclosure is by completing a deed in lieu of foreclosure. In this kind of transaction, a homeowner voluntarily hands over the home's title to the bank to satisfy the mortgage loan.

Because the difference in how a foreclosure or deed in lieu affects your credit is minimal, it might not be worth doing a deed in lieu unless the bank agrees to forgive or reduce the deficiency, you get some cash as part of the deal, or you get some extra time to live in the home (longer than what you'd get if you let the go through). Banks sometimes agree to these terms to avoid the expense and hassle of foreclosing.

If you have a lot of equity in the property, however, a deed in lieu is usually a poor choice. You'd be better off by selling the home and paying off the debt. If you don't have a lot of time and a foreclosure is imminent, you might consider filing for Chapter 13 bankruptcy and including the property's sale as part of your plan.

You should also take into consideration how long it will take to get a new mortgage after a deed in lieu or short sale versus a foreclosure. Fannie Mae, for instance, will buy loans made two years after a deed in lieu or short sale if there are extenuating circumstances, like divorce, medical bills, or a job layoff that caused you economic difficulty, compared to a three-year wait after a foreclosure. (Without extenuating circumstances, the waiting period for a Fannie Mae loan is seven years after a foreclosure or four years after a deed in lieu or short sale.) On the other hand, the Federal Housing Administration (FHA) treats foreclosures, short sales, and deeds in lieu the same, usually making its home loan insurance available after three years.

Banks sometimes require that homeowners attempt to sell the property for at least 90 days at fair market value before allowing a deed in lieu of foreclosure. Also, the property ordinarily must have clear title, which means there can't be other liens on the home.

How to Apply for a Deed in Lieu of Foreclosure

As with a short sale, to get a deed in lieu of foreclosure, you have to submit a loss mitigation application to your mortgage servicer. Again, the servicer will probably require a completed RMA form. Servicers use this form when evaluating borrowers for short sales and deeds in lieu of foreclosure, as well as other foreclosure avoidance options like modifications.

Deficiency Judgments After Deeds in Lieu of Foreclosure

In a deed in lieu of foreclosure transaction, the deficiency is the difference between the fair market value of the home and the total mortgage debt. Generally, a bank will agree to let a homeowner off the hook for a deficiency with a deed in lieu of foreclosure-but not always.

If a deed in lieu of foreclosure agreement doesn't contain language expressly stating that the transaction is in full satisfaction of the debt, the bank might later file a lawsuit to get a deficiency judgment. Again, if the debt is forgiven, you might have a tax liability.

Avoiding a Deficiency Judgment

A few ways that you might be able to avoid paying all or part of the deficiency after a short sale or deed in lieu of foreclosure are by:

Asking the bank to waive the deficiency judgment. As part of the short sale or deed in lieu of foreclosure process, you can ask the bank to waive its right to a deficiency judgment even if the bank doesn't volunteer to waive the deficiency upfront. (Again, find out whether you could potentially face a deficiency judgment in your state. If not, and the bank won't waive the deficiency as part of a short sale or deed in lieu, it might make sense to let the foreclosure happen. For specific advice about what to do in your particular situation, talk to a local foreclosure attorney.) Banks sometimes agree to waive the deficiency after a request, particularly if you don't have a lot of money in the bank or other assets that could be used to pay off the debt. If the bank agrees, be sure to get the waiver in writing. Remember that, depending on the circumstances, you might face a tax liability for the forgiven debt. Settling the deficiency for a lesser amount. If the bank won't agree to waive the deficiency altogether, it might agree to accept a lesser amount than you actually owe in satisfaction of the debt. Because a bank has to file a lawsuit to get a deficiency judgment, it's sometimes possible to convince the bank that it would be easier and cheaper to accept a smaller amount rather than going to court. Again, be sure to get the agreement in writing, and you might have tax liability for any forgiven debt. Filing for bankruptcy. You might be able to discharge (eliminate) your liability for the deficiency by filing for bankruptcy.

Getting Help

If you need help deciding which option is best for your situation, consider talking to a foreclosure lawyer.

To get help applying for a short sale or deed in lieu of foreclosure, consider talking to a HUD-approved housing counselor. A housing counselor can also provide information about other ways to avoid a foreclosure, such as a forbearance agreement, repayment plan, or modification, like a Fannie Mae or Freddie Mac Flex Modification.

To find out if bankruptcy will help in your situation, consult with a bankruptcy attorney.
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About the Author

Amy Loftsgordon is a legal editor at Nolo, focusing on foreclosure, debt management, and personal finance. She writes for Nolo.com and Lawyers.com and has been quoted by news outlets that include U.S. News & World Report and Bankrate.