Non-Recourse vs. Recourse Loans
Reviewing both types of debt structures.
A loan being "non-recourse" means that the default is secured by collateral, usually, such an asset is stable in value as property. Therefore, the lender can pursue the borrower in seeking compensation by immediately liquidating the collateral to compensate for the default.
However, the lender cannot pursue the borrower for more than the collateral. Therefore, if the default amount is higher than the collateral asset is worth, the lender must take on that difference as a loss.
This ensures the borrower is not liable for funds exceeding the collateral in the case of default. This means the borrower's personal assets are not to be pursued by the lender.
In the U.S., non-recourse loans are only available in the following twelve states::
- Alaska
- Arizona
- California
- Connecticut
- Hawaii
- Idaho
- Minnesota
- North Carolina
- North Dakota
- Texas
- Utah
- Washington
Non-recourse loans are available in the form of credit card debt, auto loans, and most home mortgages. Any government-backed debt is required to be a non-recourse structured loan.
On the other hand, a recourse loan is a type of secured debt, which means that the default amount is secured by the collateral and, if necessary, the borrower's assets. Therefore, the lender has the right to seize more than the collateral to compensate for the default amount.
Of course, if the unpaid loan amount is less than or equal to that of the collateral, the lender can simply liquidate the collateral to settle the transaction. However, recourse debt is structured so a lender has rights beyond the collateral if needed.
Most lenders prefer to give out recourse loans as it protects them from the worst-case scenario, although seizing assets tends to be a hassle. Therefore, common types of recourse loans, similar to non-recourse loans, include auto loans, credit card debt, and home mortgages.
Further, short-term debt provided for funding real estate also usually happens to be recourse debt.
As mentioned before, apart from the states mentioned where non-recourse loans are permitted, a minority of home mortgages in the United States are recourse loans.
For these recourse-structured home mortgages, the lender can go after the borrower's personal assets if needed. This means that if the collateral or the property does not satisfy the lender, the lender can claim a deficiency amount.
A deficiency amount is an amount lacking that the lender requires to be paid back. This amount can be compensated by liquidating a necessary amount of the borrower's assets. Such as other property, stocks, cash in the bank, or other assets.
Most debt issued today is made of recourse loans as most lenders prefer to have the ability to seize the borrower's assets to recoup their investments if needed. This greatly reduces their risk of lending.
How do I determine if I have recourse or non-recourse debt?
Remember, it does not matter what your loan type is unless you are delinquent. However, it can still be useful for you to know the structure of your loan.
If you want to know whether your mortgage is recourse or non-recourse, start with the list of states mentioned where non-recourse loans are allowed. Read over your documents for other types of loans and contact your lender directly.
If you believe you might default, work with your lender immediately to determine if there are any options to avoid default, such as forbearance or loan modification. This is especially important if you have a recourse loan.
Moreover, work with your attorneys and accountants throughout this entire process.
Examples of Recourse and Non-Recourse Loans
Both types of debt can be quite difficult to understand; therefore, let us run through a situation where a borrower defaults on a substantial loan amount. We can apply this example to a non-recourse and a recourse loan example.
Non-Recourse Loan Example
Assume that you take out a loan to purchase a car in Alaska, where non-recourse debt is allowed to be issued. Remember, the structure of this debt means that, in case of default, the lender cannot seize your assets.
We can highlight the following factors associated with this transaction:
- Car purchase price: $50,000
- Down payment: $10000 (20% of purchase price)
- Loan amount: $40,000
- Interest rate: 4.5%
- Loan term: 60 months (5 years)
- Total interest: $4,743.25
Suppose that an unexpected medical expense occurs right after you are issued this loan, making it difficult for you to make the monthly payments. You, unfortunately, default immediately.
The lender quickly steps in to liquidate your collateral, which is the car you purchased. The lender liquidates the asset and finds that it only satisfies $35,000 of what is owed.
The lender expects to receive both the loan amount of $40,000 plus the interest up to that point. Hence, the lender would not be fully satisfied; however, since this is non-recourse debt, the lender cannot pursue the matter.
Recourse Loan Example
Assume that you are a homebuyer who takes out a loan to purchase a property. Remember, this recourse mortgage means that, in case of default, the lender can seize your personal assets.
We can highlight the following factors associated with this transaction:
- Property purchase price: $1,000,000
- Property down payment: $200,000 (20% of loan purchase price)
- Loan amount: $800,000
- Interest rate: 4.5%
- Loan term: 30 years
- Total interest: $746,046.27
Suppose that an unexpected medical expense occurs right after you are issued this loan, making it difficult for you to make the monthly payments. You, unfortunately, default immediately.
The lender quickly steps in to liquidate your collateral, which is your purchased property. The lender liquidates this property and finds that it only satisfies $700,000 of what is owed.
Remember, the lender expects to receive both the loan amount of $800,000 plus the interest accrued up to this point. Hence, the lender would not be fully satisfied at this point.
The lender would then start seizing assets worth the deficiency amount, which, in this case, would be the remaining unpaid principal and interest. Unfortunately, the borrower would have to sell their assets to compensate the lender.
Recourse Loans vs. Non-Recourse Loans
Many factors associated with recourse and non-recourse debt cause such loan structures to create differences for borrowers and lenders. We will consider the perspective of the lender and the borrower when reviewing both types of debt structures.
The following table highlights the key factors associated with the two types of debt:
| Recourse Loan | Non-Recourse Loan |
|---|---|
| Lower interest rate | Higher interest rate |
| The lender has a claim on the borrower's personal assets on default. | The lender has no claim on the borrower's personal assets on default, thus, is limited to the collateral. |
| Most loans are structured as recourse, therefore, more loan options. | Loan options are restricted, only certain states in the U.S are allowed to issue Non-recourse debt. |
| Lenient approval requirements | Stringent approval requirements |
Remember that the elements in the table are the most common cases with each type of debt structuring. However, you should work with your lender to determine the terms being offered.
As shown in the table above, recourse and non-recourse loans share many similarities but act differently in the case of default or deficiency.
Hence, the differences in the loan structure only play out in the event of a default. Other than that, the differences in interest rates are one of the only prominent factors that stand out to both lenders and borrowers.
Let us now discuss the perspectives of a lender and borrower for both loan structures to understand which type of debt suits which scenario better.
Lender Perspective
Lenders most commonly prefer recourse-structured debt even if they receive a lower return on their investment.
This is because the lender can give out these loans to borrowers and need not worry about the default risk. After all, they can simply claim an adequate amount of the borrower's personal assets.
Further, as mentioned before, non-recourse debt is not allowed to be issued in most states in the U.S.
Therefore, lenders usually would gladly issue a recourse loan over a non-recourse loan in most cases. However, there are still cases where the risk of issuing non-recourse debt is worth it.
If a borrower has impeccable credit and is found to have a very low risk of default, then a lender may find it worth the risk to issue non-recourse debt. Although at a comparatively higher interest rate.
As mentioned before, the interest rate for non-recourse debt is higher, as the lender is taking on the risk of being unable to pursue the borrower past the value of collateral in the event of a default.
Therefore, the lender needs to make a reliable inference to judge whether a borrower is likely to pay back the debt. Lenders often conduct rigorous analyses to determine default probabilities.
Let us discuss the borrower's perspective next.
Borrower perspective
A borrower can look at the two loan options and immediately understand that a recourse loan is cheaper over its lifetime due to a lower interest rate. Further, the requirements to meet the criteria of this loan are lenient.
From the perspective of the borrower, the benefits of a non-recourse loan are only realized in case of default since the lender does not have the right to liquidate the borrower's personal assets.
Hence, you might wonder why a reliable borrower that meets the stringent approval requirements and is confident in paying back the debt would even consider taking on a non-recourse loan, given the higher interest rate and lack of loan options.
It is imperative to recognize that individuals have different risk tolerances. Even if a borrower is confident in his ability to pay back the lender, he may still choose to take on a non-recourse loan at an added cost to protect himself from the worst in case of default.
Therefore, risk-averse borrowers may find the cost worth it, even if the probability of a default occurring seems minuscule. This would mean that the borrower is paying a premium to ensure that the lender cannot seize their personal assets.
Conclusion
There is no definitive answer as to which loan type is better. Individuals should make a judgment on their risk tolerance and the confidence they have in their ability to make payments.
This makes a self-reflective analysis imperative to help potential borrowers choose the right loan option for them. Always remember that unexpected circumstances can impact anyone. A non-recourse loan safeguards against such events, although for a premium.
Hence, given the risks and benefits associated with both loans, an individual should conduct a self-analysis to determine their risk tolerance and goals. You can also work with your lender throughout this process.
It is crucial to recognize that both loans offer capital to a borrower at a risk. Therefore, you should explore other debt offerings from your lender so that you can make an informed decision that considers all available options.
Today, there are many debt structures that exist. Ask your lender and be transparent about your confidence in making repayments on various terms. A lender can create a unique loan structure for you if needed.
Should an unfortunate situation arise, submit a complaint to the Consumer Financial Risk Bureau (CFRB).
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