Recourse vs. Non-Recourse Loans: An Overview
A recourse loan allows a lender to pursue additional assets when a borrower defaults on a loan if the debt’s balance surpasses the collateral’s value. A non-recourse loan permits the lender to seize only the collateral specified in the loan agreement, even if its value does not cover the entire debt.
Either type of loan may be collateralized. That is, the loan agreement will specify that the lender can seize and sell specific property or properties of the borrower to recoup losses in case the loan defaults. However, a recourse debt gives the lender the recourse to pursue additional assets of the borrower beyond the value of the collateral if it is necessary to recoup its losses on the loan.
- There are two types of loans—recourse and non-recourse.
- Both recourse and non-recourse loans allow lenders to seize collateralized assets after a borrower fails to repay a loan.
- After collateral is collected, lenders of recourse loans may go after a borrower’s other assets if they have not recouped all of their money.
- Lenders can collect the collateral from a non-recourse loan but cannot go after the borrower’s other assets by law.
- Non-recourse loans may have stricter terms, higher rates, and other conditions recourse loans will not have.
Contrasting Non-Recourse And Recourse Loans
Recourse loans have a lower interest rate than non-recourse loans. If the borrower fails to live up to their obligation and default on the payment schedule, the lender will first seize and sell the collateral specified in the loan. If that is not of sufficient value to repay the loan amount, the lender can go after the borrower’s other assets or sue to have the borrower’s wages garnished.
From the lender’s point of view, a recourse loan reduces the potential risk associated with less creditworthy borrowers. Because lenders can reduce the risk associated with these loans, they can charge a lower interest rate. This makes them more attractive to borrowers.
If you abandon collateral offered for a recourse loan, you’ll need to claim a capital gain or loss when foreclosure completes.
These loans are most common when banks and other financial institutions tighten their lending practices. For example, when the economy is going through rocky times, the credit markets get more conservative, and lenders raise their standards.
Examples of Recourse Loans
Most automobile loans are recourse loans. If the borrower defaults, the lender can repossess the car and sell it at fair market value. This amount may be less than the amount owed on the loan because vehicles depreciate significantly in their first couple of years. If there’s a balance left on the loan, the lender can go after the borrower’s other assets to recoup the remainder of the debt.
Most mortgage loans are recourse loans, except in 12 states that forbid recourse home loans. Those states are Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah, and Washington.
It is important to note that lenders don’t always pursue assets beyond the collateral in default cases, especially by individuals. Seizing assets is time-consuming and expensive, and a lender may write off a loss rather than continue to pursue it.
Many banks do not offer non-recourse loans. It leaves them vulnerable to losses if their customers default on their loans and their collateral proves insufficient. If there’s a balance due after selling the asset collateralized with the loan, the lender has to take the loss. It has no claim on the borrower’s other funds, possessions, or income.
While potential borrowers may find it attractive to hold out for non-recourse loans, they usually come with higher interest rates. They are also generally reserved for individuals and businesses with stellar credit histories. A non-recourse loan is not a get-out-of-a-loan-free card; failure to pay off a non-recourse debt has penalties, including loss of the collateral, damage to the borrower’s credit score, and possible taxes.
If you abandon collateral used for a non-recourse loan, it is viewed as a sale or exchange by the Internal Revenue Service and is taxed as a capital gain or loss.
Example of a Non-Recourse Loan
As noted, many traditional banks avoid making non-recourse loans altogether. However, an individual or business with an excellent credit history might persuade a lender to agree to a non-recourse loan. It will come with a higher interest rate. It may also come with tougher terms, such as a larger down payment on a home or a car.
Do Banks Do Non-Recourse Loans?
Most banks do not offer non-recourse loans. Some might offer them to preferred borrowers, but terms and rates can be much higher.
What Is a Non-Recourse Loan and Who Benefits From It?
A non-recourse loan is one in which the lender cannot go after more than the collateral offered for the loan. This type of loan is beneficial for the borrower because the lender cannot seize other assets to recoup their losses.
What Is an Example of a Non-Recourse Loan?
Some states have non-recourse mortgage laws, such as North Carolina and Texas. In these mortgage loans, the lenders can foreclose on the home but cannot attempt to seize other assets to make up for the loss.
Do You Have to Pay Back a Recourse Loan?
A recourse loan is a type of loan. It must be paid back if it is in the loan’s terms and conditions. If it cannot be paid back in full with interest specified in the contract, the lender can seize other assets to recoup losses.
The Bottom Line
A recourse loan is a loan where the lender can seize the collateral and other assets to recoup any losses. A non-recourse loan is one where the lender cannot seize more than the collateral offered.
Most lenders do not issue non-recourse loans because doing so exposes them to more risk. However, banks may offer them to specific customers based on financial circumstances or customer needs. As a result, non-recourse loans are likely to have higher rates, larger down payments, or other conditions.