Why won't my lender accept a deed-in-lieu of foreclosure?

By Gina Pogol
Mortgage Credit Problems Columnist

Dear Gina, I lost my job over a year ago and finally got a new offer, but it's in another state. I have two mortgages on my home and it's underwater. I want to give the home back to the lender (I think it's called a deed-in-lieu?). I am trying to avoid the bad credit of a mortgage foreclosure but the lender won't just accept the deed. Why? - David, Yuma, Ariz.

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Dear David,

Congratulations on your new job. I can understand why you want to give the house back, and you are right; a deed in lieu of foreclosure is generally better for your credit than a foreclosure. However, when there is a second mortgage, your first mortgage lender is probably better off foreclosing because of the way the law works.

First and second mortgage foreclosures

When you have one mortgage, that lender gets paid in the event of a foreclosure sale. To the lender, this is called being the primary lienholder or being in first position. The lender on a second mortgage or home equity loan is in second position and is called a junior lienholder. That lender only gets paid if the proceeds of the foreclosure sale are sufficient to take care of the primary lienholder's claims first.

In an underwater situation, the primary lienholder may foreclose, the property may be sold -- and if there is no money for the second mortgage lender, its lien is extinguished and it gets nothing.

However, if the first mortgage lender accepts a deed in lieu of foreclosure from you, the second mortgage does not go away. While your primary lender could avoid the cost of a foreclosure by accepting your deed, it would also acquire the debt owed to the second mortgage lender, and it won't want to do that.

Try negotiating a short sale

Since you have tried to sell your home, you know that the price will have to come down to get a buyer. Get a real estate agent with a very good short-sale track record, and list the property.

You will need to negotiate with the second mortgage lender; for some portion of the balance owed, it may agree to release its lien, which will be worthless anyway if the primary lienholder forecloses. When you have an offer on the table, your first mortgage holder may allow you to close and walk away with minimal damage to your credit. Rather than a foreclosure, you may get something like "creditor settled for less than amount owed" or some such notation on your credit report.

Even so, it is unlikely that you will be able to buy a new home any time soon; even bad credit mortgage lenders will want to see a very large down payment before they will finance your next home purchase.

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