Recourse loans are a type of secured debt that lets lenders recoup defaulted loan balances by seizing both the loan collateral and—when necessary—the borrower’s other assets. Common types of recourse debt are auto loans and home mortgages.
In the case of default, the lender can seize and sell the collateral. If that collateral is not enough to cover the outstanding loan balance, the lender can then go after the borrower’s other assets. Recourse loans pose less risk to lenders, so they usually have lower interest rates and are more widely available.
Non-recourse debt also is secured by a borrower’s collateral. However, in the case of default, the lender only can seize the collateral specified in the loan documents and cannot go after the borrower’s other assets. Few banks offer non-recourse loans, but home mortgages are treated as non-recourse loans. Non-recourse debt also has higher interest rates and more restrictive borrower qualifications than recourse because non-recourse debt is riskier for lenders.
In a nutshell, the difference between recourse and non-recourse debt is the ability of the lender to take the assets of the borrower if the debt is not paid. Non-recourse debt favors the borrower, while recourse debt favors the lender. When a lender is given recourse rights in a borrowing arrangement, it means that the lender can pursue repayment of the debt from the borrower by seizing designated borrower assets. Thus, recourse debt refers to an agreement where the lender can attach borrower assets, while non-recourse debt refers to an agreement where the lender cannot do so (other than for assets specified as collateral). However, a recourse arrangement may only allow the lender to attach specifically identified borrower assets, beyond which the lender has no ability to obtain additional borrower assets. In this case, the existence of a recourse feature may not provide complete risk mitigation for the lender.
A lender is most able to impose a recourse debt agreement on a borrower when the borrower is unable to obtain financing elsewhere on better terms, and especially when the borrower is in difficult financial circumstances. Conversely, a borrower may be able to demand non-recourse debt terms if it can select from many lenders and has such excellent financial results and asset reserves that it can justify its demands.
A lender may be more willing to grant credit under a recourse loan at a lower interest rate than would be the case with a non-recourse loan, since the lender’s risk of repayment is reduced under a non-recourse situation. Consequently, some borrowers are more willing to accept recourse terms in exchange for a reduced interest rate and/or other, more lenient borrowing terms. Alternatively, a lender may be willing to grant less credit under a non-recourse agreement, usually only up to the amount of any collateral posted against the note. Since the lender has no recourse above the amount of the collateral, it is too risky to extend additional credit.
A lender has more power in a tight credit market, and so is more capable of imposing recourse terms. The reason is that fewer lenders are willing to issue funds, which minimizes the level of competition among lenders for the business of borrowers.
Recourse Loan Example
If a borrower takes out a $20,000 auto loan to purchase a $25,000 car, the debt will be secured by the vehicle. If, after several payments, he defaults on the loan with $16,000 remaining on the loan, the lender can repossess the car and sell it to recoup the outstanding loan balance. However, if the car has depreciated and can only be sold for $12,000, the lender can also get a deficiency judgment from a court and then garnish the borrower’s wages to collect the remaining $4,000.
Non-Recourse Loan Example
Consider a homebuyer who takes out a $250,000 mortgage to purchase a house with an appraised value of $300,000. If the homeowner defaults on $230,000 of the loan, the bank can foreclose on the collateralized property to try to recoup the outstanding debt. However, in some states, if the local real estate market is flooded with inventory and the house can only be sold for $215,000, the lender cannot recoup the additional $15,000 through wage garnishment or other means.
Recourse Loan Vs. Non-Recourse Loan: Which Is Better?
Regardless of whether a secured loan is recourse or non-recourse, the lender can seize the borrower’s collateral in the case of default. The primary difference is that with a non-recourse loan, the lender can only seize the specific collateral—even if it’s worth less than the outstanding debt. With a recourse loan, however, the lender can seize the borrower’s collateralized assets and—if it can’t recoup the outstanding loan balance by selling that collateral—can then go after the borrower’s other assets.
The best loan option depends on the borrower’s needs, creditworthiness and confidence in their ability to make on-time payments. You’re likely to get a recourse loan if you:
Have a weak credit history or high debt-to-income ratio. In addition to lower interest rates, recourse loans also have more lenient loan approval requirements. If you have a low credit score or have a high debt-to-income ratio—meaning a large percentage of your income goes to debt service each month—you’re most likely to get a recourse loan.
Want a lower interest rate. Recourse loans are not as risky for lenders as non-recourse loans because lenders have more flexibility when recouping outstanding debt in the case of default. For that reason, lenders can offer more competitive interest rates on recourse loans than they can for non-recourse loans.
Are taking out an auto loan or credit card.
Certain types of debt—like credit cards and auto loans—are typically structured as recourse debt. For that reason, borrowers must agree to recourse loan terms if they want to take advantage of many traditional financing options.
Non-recourse loans may be an option if you:
Can satisfy more stringent approval requirements.
In rare cases, borrowers with a high credit score and a low debt-to-income ratio may be able to get a non-recourse loan.
Are willing to pay a higher interest rate.
Likewise, a higher interest rate protects lenders that are exposed to riskier non-recourse loans.
How to Determine Your Loan Type
Generally speaking, it doesn’t matter whether your loan is recourse or non-recourse unless you are delinquent in your loan repayments.
If you have a debt, like an auto loan, you can determine your loan type by reviewing your original loan documents or by contacting your lender directly. If you confirm you have a recourse loan and think you may default, talk to your lender about options to avoid default—like forbearance or loan modification. You should also work with your lawyer or accountant to evaluate the implications of default and foreclosure
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Mark Darko, Accra