A voluntary foreclosure refers to a foreclosure initiated by a borrower. The borrower willingly enters a foreclosure because they are unable to make loan payments, or they wish to avoid making any future payments. Possession of the property is transferred from the borrower to the lender.
If the borrower struggles to make payments or avoids making payments altogether, an involuntary foreclosure will ensue. The foreclosure is initiated by the lender to seize possession of the property, possibly leading to eviction for the borrower.
If involuntary foreclosure and eviction seem inevitable, a voluntary foreclosure is often the better option for the borrower. They can leave the property on their own terms and end their loan payments sooner.
A voluntary foreclosure is initiated by a borrower to transfer possession of a real estate property to a lender. It happens when a homeowner is no longer able or willing to make mortgage payments on the debt they used to finance the property.
Ownership of the property is transferred from the borrower to the lender in exchange for releasing the borrower from payment obligations.
A voluntary foreclosure is preferred by borrowers and lenders over the more difficult and time-consuming process of an involuntary foreclosure.
Effects of Voluntary Foreclosure
A voluntary foreclosure will result in a hefty ding to the borrower’s credit. This will make it difficult to get approval for other loans, credit cards, and other forms of credit. The effects of foreclosure may even affect the borrower’s ability to get a job. With that said, a voluntary foreclosure is more favorable than an involuntary foreclosure. Opting for a voluntary foreclosure will at least mitigate the damage.
The American Housing Bubble
Voluntary foreclosures can go by other names, including a friendly foreclosure, mortgage release, walking away, and strategic default. Voluntary foreclosures became widely used during the Great Recession.
With the American housing bubble and subprime mortgages, borrowers struggled to make payments on their mortgages. They borrowed beyond their means, and the recession left many unemployed, which exacerbated the financial strain mortgage payments caused. On top of the difficult situation, housing prices plummeted, and many mortgages went underwater, which meant that the amount that borrowers owed exceeded the value of the home.
Prior to the housing bubble in America, voluntary foreclosures were hardly used, and the phrase itself was hardly mentioned. Voluntary foreclosures became common at the end of the 2000s. The effects of the American housing bubble were so large that voluntary foreclosures are still common today. For some borrowers, the value of their homes remains below the value of their mortgage.
Deed in Lieu of Foreclosure
A deed in lieu of foreclosure refers to a document used for most voluntary foreclosures. The deed will transfer ownership of the property from the borrower to the lender in exchange for releasing the borrower from payment obligations. Using the process with the deed in lieu of foreclosure helps avoid a costly and time-consuming standard foreclosure. It benefits both the lender and the borrower.
To initiate the process, the borrower will submit a loss mitigation application to their mortgage provider. If all goes well, the borrower will be relieved of their debts on the property, though this is not always the case. Sometimes, there will be a deficiency judgment.
A deficiency is the difference between the market value of the property and the mortgage debt. Lenders may or may not waive the deficiency debt with a deed in lieu of foreclosure. If they do not waive the difference, the borrower can face a deficiency judgment and will be obligated to pay the difference. Borrowers need to ensure the deed contract states they will not be liable for the deficiency.
Pros of Voluntary Foreclosure
1. Ends payments sooner
A voluntary foreclosure is used as a last resort for the borrower but can offer the quickest path to relief. The voluntary foreclosure process is much faster than a typical foreclosure. Also, this foreclosure is initiated by the borrower so the borrower can decide at any time whether or not they can, or will, make payments.
2. Option to leave on own terms
Leaving on your own terms is much better than being forcefully evicted through an involuntary foreclosure. When a borrower chooses a voluntary foreclosure, they can make plans for their next move. It relieves one stress of the foreclosure process – where you will live next.
3. Less credit impact than involuntary foreclosure
A voluntary foreclosure impacts your credit to a lesser degree than an involuntary foreclosure. The use of a deed in lieu of foreclosure is known to soften the credit impact and shorten the length of the impact. Involuntary foreclosures can ruin credit for seven years, whereas a deed in lieu of foreclosure may only result in an impact of four years.
4. Faster and easier process for lenders
In comparison to an involuntary foreclosure, a voluntary foreclosure can be a win-win for the borrower and the lender. The process is faster and more hassle-free for both sides.
Cons of a Voluntary Foreclosure
1. Credit is still severely impacted
While the credit impact of a voluntary foreclosure is lighter, the impact can still be devastating. Your credit score will plummet, which will result in a rippling effect that leads to other consequences.
2. Housing and employment issues
Some of the consequences include housing and employment issues. Your credit will affect what housing you can qualify for and the interest rates you receive on any future mortgages. That’s if you can manage to get approved. Lenders may not lend to you if they know that you previously voluntarily foreclosed. It will create obstacles you’ll need to overcome to get a roof over your head.
Employers nowadays may check the credit reports of candidates they are considering hiring. It is a safety measure but can shed light on you as a borrower and how you would be as an employee. It is especially the case if the job deals with managing money. A subpar credit score can raise a red flag.
3. Deficiency judgment
A deficiency judgment can potentially result from a voluntary foreclosure. The relief of 100% of the borrower’s debt is common but is not certain. The borrower may be liable to pay the difference between the value of the home and the debt of the mortgage.
They may be liable to pay 100% of the difference or a portion of it. Either way, it would create a financial burden. Borrowers should be aware of the terms when they initiate a voluntary foreclosure with a lender.
4. Potential taxes owed for debt relief
If a deficiency is forgiven, there can be tax consequences for this forgiven debt. When debt is canceled, the IRS considers that taxable income. So, a debt may be erased, but a tax bill could come along with it.
Owing taxes on the debt is much easier to pay off than the debt itself, but the tax bill can still be costly and difficult to pay when a borrower is already tight on cash.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: