When you borrow money, it’s important to understand what’s at risk. What happens if you fail to repay the loan?
If it’s a recourse loan, the lender/ investor can come after you , as apposed to simply going after the collateral (the collateral might be property you purchased with the loan proceeds. With a non-recourse loan, on the otherhand, the lender does not have as many options, so the lender is taking more risk. Let’s dig in to this.
Recourse Loans -The Recourse
Recourse loans get their name from the fact that lenders have power. They are allowed to go after you for amounts that you owe – even after they’ve taken collateral. If you default on a recourse loan, the lender can bring legal action against you, garnish your wages, levy bank accounts, and use other methods to collect the amount you owe.
For example, assume you borrow money to buy a home. You fall on hard times and are unable to pay the mortgage.
Your lender forecloses and sells the home, but your home was underwater due to a weak housing market (and the sales price was not enough to cover what you owe). What happens then? If your loan was a recourse loan, the lender will be able to continue trying to collect from you by taking legal action.
A legal action to collect money after foreclosure is generally called a deficiency judgment.
The essential difference between a recourse and non-recourse loan has to do with which assets a lender can go after if a borrower fails to repay a loan. As a matter of principle, borrowers almost always favor non-recourse loans, while lenders almost always favor recourse loans.
In both types of loans, the lender is allowed to seize any assets that were used as collateral to secure the loan. In most cases, the collateral is the asset that was purchased with the loan. For example, in both recourse and non-recourse mortgages, the lender would be able to seize and sell the asset to pay off the loan if the borrower defaults.
The difference comes “if money is still owed after the collateral is seized and sold“. In a recourse mortgage, the lender can go after the borrower’s personal assets or sue to have his or her wages garnished.
In a non-recourse mortgage, however, the lender is out of luck. If the asset does not sell for at least what the borrower owes, the lender must absorb the difference and walk away.
While potential borrowers might find it attractive to hold out for non-recourse loans, it is important to remember that they come with higher interest rates and are reserved for individuals and businesses with the best credit. Additionally, failure to pay off a non-recourse debt may leave other assets unharmed, but the borrower’s credit score will be affected in the same way as a failure to repay recourse debt.
A non-recourse loan does not allow the lender to pursue anything other than collateral. For example, if you default on your non-recourse home loan, the bank can only foreclose on the home. They generally cannot take further legal actions against you. The bank is out of luck even if the sale proceeds do not repay the loan.
Non-recourse loans create the most risk for lenders. Because they can only collect the collateral – and nothing else, they want to see lower loan to value ratios to reduce their risk. These loans may have higher interest rates than recourse loans.
Identifying Loan Types
You should consult your attorney or tax adviser be certain whether you have a recourse loan or a non-recourse loan. However, you can use the information below for discussion.
State laws often dictate whether a loan is a recourse loan or not. California is best known as a non-recourse loan state that makes it hard for lenders to sue. Some states give lenders flexibility in how they pursue defaults, but many lenders choose not to sue because defaulting borrowers often don’t have much to sue for.
- List of State Laws on Recourse Loans
Look up your state and see your state’s rules on deficiency judgments.
Refinances, second mortgages, and “cash out” transactions tend to create recourse loans (even if you previously had a non-recourse loan)
Purchase loans for your primary residence are most likely non-recourse loans in non-recourse states.
Recourse Loans and Taxes
In the event of default, your tax liability may depend on whether or not you have a recourse loan. Our tax expert discusses these issues in his article: Foreclosures and Taxes.