Understanding the Difference Between Recourse and Non-Recourse Debt and Why it Matters to You
Debt is a complex topic. It can help you buy a house or fund college, but it can also cause significant stress and financial strain when misused.
Understanding the difference between recourse and non-recourse debt — and why it should matter to you — can help make managing your finances more straightforward and manageable.
Recourse Vs. Non-Recourse Loans - Defining the Terms
Simply put, a recourse loan will allow a lender to pursue additional assets when a borrower defaults. If the debt balance of the loan from the borrower surpasses the collateral value, this is when a lender would pursue the additional assets.
A non-recourse loan only permits the lender to seize the collateral specified in the loan agreement, even if its value does not cover the entire debt of the loan.
Recourse and non-recourse loans can be collateralized. This means that in the loan agreement, you allow the lender to cease the deal and sell specific property or properties if you cannot pay the loan and end in default. This allows the lender can recoup their losses.
However, as noted above, a recourse debt or loan allows the lender to pursue other collateral items if necessary to recoup losses on the loan.
A Closer Look at Recourse Loans
So if a recourse loan comes with the risk of the lender seizing additional assets if you default, why would you, as a borrower, seek a recourse loan?
Recourse loans have much lower interest rates than non-recourse loans. This makes it much more appealing to those who are looking to pay down loans faster, are looking to save money in the long run, and are sure that they won't default.
If the borrower fails to live up to their end of the bargain on the loan in default on the payment schedule, the lender will seize, then sell, the collateral specified in the loan agreement. Suppose the collateral agreed upon in the loan agreement does not satisfy or cover the debt owed on the loan. In that case, the lender can go after the borrower's other assets or sue the borrower to have their wages garnished in the future.
From a lender's perspective, having a recourse loan reduces their potential risk with less credit-worthy borrowers or, better put, borrowers with lower credit scores. Since lenders can reduce the risk associated with these types of loans, they can charge a lower interest rate making them more appealing to buyers, as noted above. During financial crises like recessions, these types of loans become more common.
Where Will You Find Recourse Loans
The most common type of recourse loan is found when it comes to insuring vehicles. The lender can repossess a vehicle and sell it at fair market value. Then, because a car depreciates significantly in the first couple of years, the lender can go after the remainder of the debt in the ways outlined in the previous paragraph. Most mortgage loans are recourse loans except within 12 states that do not allow them: Alaska, Arizona, California, Connecticut, Minnesota, North Carolina, Idaho, Texas, North Dakota, Washington, Utah, and Oregon.
Non-Recourse Loans and How They Work
It could be tough for you to find a bank that offers non-recourse loans, as many do not offer them. It leaves banks vulnerable to their losses if a customer or borrower defaults on their loan and their collateral does not have sufficient funds to cover the debt.
While many borrowers might find it attractive to hold out for a non-recourse loan, they usually have very high-interest rates and are generally only reserved for individuals and businesses with fantastic credit scores and impeccable credit histories. A non-recourse loan is definitely not for those in danger of default! If you are to default on a non-recourse loan, you will have collateral damage to your credit score and possible back taxes.
If you are okay dealing with the high-interest rate and often larger down payments, non-recourse loans give you the security that the lender cannot see his other assets to recoup their losses if, in the future, you are to default on this loan.
Some states have a non-recourse mortgage law, such as North Carolina and Texas. That means mortgage loans and lenders can foreclose on your home but cannot attempt to seize other assets to make up for their losses. This means you wouldn't need to worry about losing more than just your home and the event of a default.
The Bottom Line - Recourse vs. Non-Recourse Loans
The bottom line is that a recourse loan means a lender can seize the collateral you have defaulted on, plus any other assets you have, to recoup their losses. A non-recourse loan means a lender cannot take more than the loan's collateral to recoup their losses.
Many lenders will not issue non-recourse loans because it exposes them to extreme risks unless borrowers have a strong history of loan repayment and a sizeable down payment. If you do qualify for a non-recourse loan, be prepared to have a high-interest rate and adhere to other loan conditions.
David Price MD is the Founder and CEO of getFREED, a business providing real estate education and vetting of individual deals to help physicians and other healthcare professionals build a passive stream of income, allowing them to work less and practice on their terms.
David lives with his wife and two daughters in Atlanta, GA, USA.
To find out more about David and getFREED, head to http://www.get-freed.com.