Short Sale vs. Foreclosure vs. Deed in Lieu: Difference, Pros & Cons
Even though the information on this web page is provided by a qualified industry expert, it should not be considered as legal, tax, financial or investment advice. Since every individual’s situation is unique, a qualified professional should be consulted before making financial decisions.
In this article, I am going to be discussing the differences between a short sale, foreclosure, and a deed in lieu. I will explain what they are, the pros and cons of each method for a homeowner. And then, I will compare all the options between each other.
In fact, we’ll make the exact comparisons and analysis that I use with my own clients when they are deciphering what their best option is.
Let’s dive right in.
What Is a Foreclosure?
Foreclosure Definition and Explanation
Foreclosure is a word we often hear getting thrown around by lenders, realtors, lawyers, and the like.
So, what is the actual meaning of a foreclosure? A foreclosure is when the homeowner falls behind on their mortgage payments. As a result of this default, the bank takes back ownership of the property and sells it at a foreclosure auction.
Here is an example of what I mean: Bill purchased his home back in 2015, after landing a great job at his dream company. Unfortunately, Bill’s company shut their doors four years later, laying off hundreds of employees, including Bill. Due to his job loss, he was unable to afford his monthly mortgage payments. Bill’s lender foreclosed on the home and sold it at a foreclosure auction.
Foreclosure vs Pre-Foreclosure—What’s the Difference?
As you frantically research foreclosure options on the Internet, I’m sure you come across the term “pre-foreclosure” a lot in searches and articles.
What is the difference between a pre-foreclosure and foreclosure?
As we discussed above, a foreclosed home is a property that has already been taken back by the bank and is likely up for foreclosure auction. Consider the example of Bill and his home.
A pre-foreclosure is when the lender issues the borrower a notice of default (NOD). It’s also called ‘active foreclosure’, because in this stage of the process, the foreclosure is initiated, but not yet completed. Additionally, the homeowner typically still has time to rectify the situation.
For example: Tim is falling a few months behind on his mortgage payments, due to an unforeseen hardship in his life. One day, Tim receives a notice of default (NOD) letter from his lender. The letter indicates that his home is now in the pre-foreclosure process: the stage before the property is foreclosed upon. Tim realizes he must act quickly to discover his work-out options.
Pros and Cons of Foreclosure for the Homeowner
Benefits of Foreclosure
If your credit and financial resume are not important to you, then a foreclosure may not be the worst thing in the world.
Foreclosures often come with unwanted hard-ache and stress. The extra baggage can include other expenses piling up against the home, including unpaid property taxes, water/sewer bills, gas liens, secondary mortgage holders, etc.
When the bank takes back the house, all liens usually go with it. Some counties have stricter laws than others, regarding unpaid utility bills that actually go against the homeowner as a personal judgement. Prior to making any decisions, do your due diligence on the respective county in which the subject property is located.
Another potential benefit of foreclosure is getting a fresh start. Losing your home is definitely not an easy pill to swallow, but it will grant you the opportunity to look forward and see what the future has in store. In essence, move on with your life.
Drawbacks of Foreclosure
While there are some potential benefits of foreclosure, there is definitely a greater downside to letting the lender take back your home.
Here are three pitfalls for sellers who foreclose:
First, your credit will be heavily affected and can drop your score anywhere from 85-160 points. The decline in points will depend on the current status of your credit score.
Second, aside from a reduction in credit score, a foreclosure on your record may cause future creditors to have a negative opinion of you. This includes, but is not limited to, banks, credit card companies, credit unions, etc. This unfavorable view of your financial resume may result in loans and other lines of credit being declined, or even accepted with unfavorable terms (high interest rates, short pay back periods, etc.).
Third, although the lender is agreeing to take the home back instead of making the borrower pay, you’ll likely still have to deal with the IRS tax bill on the deficiency balance. In other words, the IRS may require you to pay taxes on the difference between the foreclosure sales price and the remaining balance on your mortgage.
Should I Let the Bank Foreclose on My Home?
At this point you’re probably thinking: should I let my home go into foreclosure?
Now, I’ll ask that you enter into a more in-depth self-examination and ask yourself: Is foreclosure right for me?
Take out a pen and paper and write down how your life would be negatively and positively affected if you were to allow foreclosure to occur on your home.
Consider the benefits and drawbacks expressed above. Be sure to add in negatives and positives that coincide specifically to your life, if your house was foreclosed and sold.
At the conclusion of this exercise, you should be closer to your answer.
What Is a Short Sale?
Short Sale Definition and Explanation
Let’s take a look at the meaning of a short sale in real estate.
A short sale is when the lender allows the borrower to sell the home for less than what is owed on the mortgage balance. In layman’s terms, the bank is taking a loss on the property.
Here is how it looks in real life:
Nancy’s mortgage balance with Old Forge Bank is $100,000. However, her home is only worth $70,000. In a short sale situation, the lender (Old Forge Bank) allows Nancy to sell the property for the $70,000 that it’s worth. The remaining $30,000 balance is wiped away clean and the seller is able to walk away from the home. Most importantly, this transaction does not get recorded as a foreclosure.
Short Sale vs Regular Sale—What’s the Difference?
There are two key factors which determine whether a homeowner is able to sell through a short sale or a normal sale:
The two components are home equity and mortgage delinquency.
Home equity is the difference in value between your mortgage balance and the value of your home.
For example, if you owe the bank $100,000 on your mortgage and your property is worth $150,000, you have $50,000 worth of equity.
Mortgage delinquency is when the borrower falls behind on their monthly mortgage payments to the bank. Defaulting a minimum of 30 days puts you in delinquent status.
If a homeowner is delinquent on their monthly mortgage payments, but their home has equity, they may be able to perform a standard sale.
In some situations, a homeowner doesn’t have equity in their home. This means that they owe their lender more money than the home is worth in the current market. This type of situation can occur as a result of a drop in local real estate prices after they took the home loan. In this case, the sale of the house will not cover their debt completely.
When a seller has no home equity (underwater) and is in delinquent status on their monthly mortgage obligations, a short sale is their best option to get rid of the property and avoid foreclosure.
Quick Sale vs Short Sale—What’s the Difference?
The term “quick sale” is most often used by lenders and homeowners. It refers to the outcome each party is hoping for: a quick sale of the property.
An example of a quick sale would be a seller listing their home for sale, then a buyer making an offer after just 7 days on the market.
A short sale is when the lender approves the terms of sale and accepts an offer that is lower than the amount owed on the mortgage balance.
As a reference point, refer back to the example of Nancy.
Pros and Cons of a Short Sale for the Homeowner
Benefits of a Short Sale
Avoid Foreclosure
When a property is successfully sold through a short sale, a foreclosure does not go against the homeowner’s financial record or credit report. This is a huge benefit if you plan on applying for any type of financing in the near future!
Regain Your Peace of Mind and Financial Freedom
As a foreclosure looms, so do threatening emails, letters and calls from creditors. Not to mention the financial and emotional difficulty of maintaining the property itself. As a short sale concludes, you’ll regain the peace of mind you’ve once had.
Possibility of Relocation Assistance
Relocation assistance is monetary compensation the lender offers the borrower to move out of the home, after a short sale. The amount of money typically ranges between $1,000-$3,000, but could be more. The defaulting home must be listed as your primary residence, in order to be eligible for relocation assistance. This type of borrower assistance is only available on a case by case basis, as not all lenders offer it.
Possibility of no Deficiency Judgement
A deficiency judgement is the difference of what the home sold for and your mortgage balance. In other words, it’s the amount the bank lost in the short sale. A lot of times the lender will waive their right to collect the balance owed. Its extremely vital the short sale processing company, attorney, or real estate agent makes sure this verbiage is incorporated into the short sale approval letter.
If you want to learn more about how the taxation of the deficiency balance works and when the tax can be avoided, read my article How Does a Short Sale Affect Your Taxes?
Lender Covers Seller’s Closing Costs
In a typical short sale scenario, the lender is responsible for the closing costs on the seller’s side of the settlement sheet. Based off of the borrower’s income, the lender can ask them to contribute a small portion. In our experience, this is less often the case.
Avoid Legal Fees Paid to Foreclosure
Attorney Foreclosures are very time consuming and expensive. Especially in judicial states, where the bank must take you through the court system.
Lenders Like Short Sales
Believe it or not, it is typically in the best interest of the lender to allow a short sale. Here are a few reasons why:
- foreclosures are cost intensive and take up time for banks
- defaulting debt looks bad on their books
- they do not have any interest in owning and managing real estate.
Drawbacks of a Short Sale
Your Credit Still Takes a Hit
Overall, a short sale is much more beneficial for you than a foreclosure. However, to say there is not any negative impact is untrue. A short sale can knock your credit score down anywhere from 60-100 points. Possible more, if your score was already high to begin with.
Read my other article about how a short sale affects credit and how long it says on your report to learn about the consequences of a short sale in more detail.
Lender Has Final Say
The nice part about a short sale is the seller is still involved in the process. They get to review, decline, and counter offers, in order to choose which is submitted to the bank. However, the lender makes the final decision on accepting the offer, negotiating the terms of sale, and setting a closing date.
You Don’t Avoid Taxes!
Upon facilitating a successful short sale, you will not have to pay the bank back the large balance you owe! Great news! ….Not so fast….
The IRS will issue you a 1099-C tax form, along with a tax bill for the amount you owe the lender. I guess, it still beats coming out of pocket for the difference at settlement!
When and Why Should You Do a Short Sale on Your Home?
The answer to the first question is easy:
NOW!
The moment you decide that a short sale is the best move for you and your family, act on it immediately by contacting a short sale processing company, also known as short sale negotiator.
You can get in touch with a reputable short sale processor in your location who handles the whole process at no cost to homeowners by filling out this form. Or, read more about what they are and how they work in my article ‘What Does a Short Sale Negotiator Do for the Seller?’.
The worst mistake people make is waiting too long.
Remember this: Your lender waits for no one. As soon as your loan goes into default, the clock is ticking towards the foreclosure auction date!
The answer to “why” is not so easy.
Carefully review the benefits and drawbacks listed above, as well as contact a short sale specialist, in order to determine whether or not a short sale is right for you.
Generally, if you do not want a foreclosure against your financial history and credit, then a short sale is the correct path to take.
If you consider a short sale a possible solution and want to learn more about it, read my other two in-depth articles:
And if you are reading this article to understand the difference between a foreclosure and a short sale because you are a beginner real estate investor, you might be interested in my article Buying a Short Sale Home [Step-by-Step Guide].
What Is a Deed in Lieu of Foreclosure?
Deed in Lieu Definition and Explanation
Another option for owners in distress is a deed in lieu of foreclosure. It is also referred to as a friendly foreclosure.
The meaning of a deed in lieu of foreclosure is when the borrower in default transfers the title of the property to the bank, then the bank cancels the foreclosure.
Think of it as a mortgage release from the lender, in return for the deed from the borrower.
Pros and Cons of Deed in Lieu for the Homeowner
Benefits of a Deed in Lieu
Peace of Mind
Foreclosures are a very stressful time for homeowners. Sometimes, if the bank allows a deed in lieu, this can alleviate much of the pressure a borrower faces.
Saving Time and Money
Particularly in judicial states, the foreclosure process can be very expensive and time intensive. A deed in lieu can potentially save you some time and money.
Drawbacks of a Deed in Lieu
A Lot of Lenders Won’t Allow It
Due to numerous lawsuits against lenders, many are now wary of entering into the process. For example, there have been countless instances where homeowners sued the bank after the deed in lieu was executed. The cases were usually based upon claims that the lender pressured them into it.
Displaced From Your Home Quickly
Of the many consequences of a deed in lieu, this is usually the toughest. Due to the lengthy procedures of the foreclosure or short sale process, the homeowner typically has ample time to remain in the home and figure out their next steps. With a deed in lieu, the time allotted is much shorter. The deed is signed over to the lender, then the owner must leave.
Leaving Money on Table
If you have any type of equity in your home, or have the opportunity to sell it through a short sale and receive relocation assistance, you’ll lose out with a deed in lieu.
Your Home Must Be Free and Clear of Other Liens
In order to be eligible for a deed in lieu option, your home cannot have any other liens against it. In the majority of foreclosure situations, the homeowner is behind on other payments related to the property.
Deed in Lieu Still Has Negative Affect on Credit
Doing a deed in lieu will reflect in a negative impact on your credit report. In some cases, it can look worse than a short sale, because the house will still get taken back by the bank in a “friendly foreclosure.”
Tax Liability for the Forgiven Deficiency Applies
A deed in lieu is no different from a foreclosure or short sale when it comes to paying taxes on the deficiency balance owed to lender and forgiven by them after they sell the property.
When Is Deed in Lieu a Good Option?
If you’re a homeowner with no additional liens against your property, that is not concerned with your credit score, or wants to move quickly, then a deed in lieu may be the right option to consider.
If a homeowner is in a situation where the bank runs a title report and offers a deed in lieu, they should carefully consider the pros and cons above, then make their decision.
Short Sale vs Foreclosure: What’s Better for the Homeowner?
After extensive independent research and reading the information above, you are left with one question: Is a short sale or a foreclosure better for my situation?
Before making this decision, let’s consider the one key difference between a short sale and a foreclosure.
In a foreclosure, the lender assumes total control over the situation, including the property and your financial future. Everything is done on their terms and for their best interests.
In a short sale, the homeowner maintains control over when and how their property sells, as well as their financial future. Although the lender ultimately approves the terms of the sale, future creditors are able to see that you made every effort possible to make things right and settle the debt.
A short sale is not right for every homeowner in every situation but overall, it is the better option.
Deed in Lieu vs Foreclosure: What’s Better for the Homeowner?
If a homeowner’s only two options are deed and lieu and a foreclosure, then a quick analysis of the pros and cons of each must come into play.
If a deed in lieu is on the table, that means the lender is willing to offer it and the homeowner is eligible. Those are both good signs.
If the owner needs more time to stay in the home and does not care about his or her credit score, then just letting the property foreclose may be the better option. It will allow them the necessary time desired to stay in the house. As stated above, a deed in lieu means the homeowner must vacate the house sooner.
A deed in lieu is better for a homeowner if they are OK with moving out of the house quicker than a foreclosure.
In terms of avoiding a default against the owner’s record, a deed in lieu is more beneficial.
Deed in Lieu vs Short Sale: What’s Better for the Homeowner?
So, your at the point now where you know a foreclosure isn’t the right option.
You’re certain that a mortgage release option is best for you and your future.
If you have equity in your home or are not underwater, then a deed in lieu would make more sense than short sale. Remember: negative equity (or close to it) is usually needed to perform a short sale.
If your property is underwater (no equity) and you’re behind on mortgage payments, then a short sale is better for you. In this case, you should contact a reputable short sale processing company, in order to gather more information about the short sale process.
Gaining lender cooperation will be more probable with a short sale. As we discussed earlier, lenders like the incentives that come along with short sales. As long as the situation qualifies, they will typically permit you to attempt short selling the home.
The same thing cannot be said for the deed in lieu process. Due to the potential liability and/or other liens against the property, lenders may choose not to work with an owner on a friendly foreclosure.
Overall, if you’re a homeowner behind on your mortgage and potentially underwater (or don’t have much equity), and want to limit credit damage, then initiating a short sale is the better choice for you.