When taking out loans, there are two types of debts: recourse and non-recourse. Recourse debt holds the borrower personally liable, and all other debt is considered non-recourse. It seems simple enough, but the average borrower might not have heard of the two different types, let alone which type of debt they may have.
These types of debts can be applied to:
- Loans
- Mortgages
- Credit Cards
- Any other types of debt
It is important that you understand what kind of debt you have, as that will help you understand your obligations and what could happen in different situations. This article discusses both types of debts, subtypes, similarities, differences, and how each kind of debt works.
If you are unsure which type of debt is better for your situation, it is important to consult an experienced finance lawyer. Our legal team here at Newburn Law can help you understand what works best for you.
WHAT IS RECOURSE DEBT?
In general, recourse debt, as mentioned above, holds the borrower personally liable for debts taken on. Recourse debts allow the lender to collect what is owed on the loan even after they’ve taken possession of whatever collateral you offered to secure the loan in the first place.
This may have been your home or something else of value, such as a vehicle or other assets you own. If the value of the collateral were not enough to cover the debt when the loan is called after default, you would still be on the hook for the remaining balance.
This could be wage garnishment or a levy on accounts in your name to collect what is owed.
WHAT HAPPENS IF YOU DEFAULT ON A RECOURSE LOAN?
So, there has been a default on a recourse loan; now what? After the lender has taken possession of the collateral, they are allowed to pursue additional assets of the borrower to cover the balance of the debt if it surpasses the value of the collateral.
Again, if after the collateral’s value is assessed and taken, the lender has not recouped all of their money from the loan, they can sue for other assets.
One thing to note here is that the recourse loan agreement may be constructed to allow the lender only to attach specifically identified borrower assets. Beyond those assets, the lender cannot obtain additional borrower assets. In this case, the existence of a recourse feature may not provide complete risk mitigation for the lender. This is called a limited-recourse or partial recourse loan.
The biggest difference between the two main types of debt is that recourse loans tend to favor the lender, giving them ample protection against losses, and non-recourse loans favor the borrower, giving the debtor more protection against asset seizure in the event of default.
HOW CAN THE LENDER COLLECT ON A RECOURSE DEBT?
The lender would need a court order to establish the right to do these types of debt collections. However, that is why it’s important to know which type of loan you are signing up for. A recourse loan will easily give the lender the right to have the court approve these types of collections. This can happen if your assets’ value does not cover the lender’s losses.
ADVANTAGES OF RECOURSE LOANS
Although a recourse loan may sound a bit scary and strict, the good news is that there are some advantages.
MORE ACCESSIBLE
For one thing, this type of loan is more accessible to individuals with lower credit scores or minimal credit history who are looking to improve in that area. Sometimes, this may be the only type of loan available to a borrower with poor credit history. Because the arrangement for a recourse loan gives the lender more protection, they might feel more comfortable lending to a “high-risk” borrower.
LOWER INTEREST RATES
Additionally, a huge benefit is that these loans usually have lower interest rates because the lender has more options for recovering any losses if the borrower defaults. From the lender’s point of view, recourse loans are much more favorable and involve much less risk overall. As long as the borrower feels confident in their ability to stay on track with payments, a recourse loan can be a great option for both parties.
AVAILABILITY OF PARTIAL RECOURSE DEBT
The other advantage of a recourse loan is something this article briefly touched on: the existence of a limited recourse loan, also known as partial recourse debt. This is somewhat of a compromise between non-recourse and recourse debt because it has all the features of a recourse loan.
For example, these have low-interest rates and a personally liable borrower. However, it limits the amount the lender can recover from the debtor to a specific dollar amount or percentage of the loan amount.
Variations of this type of loan agreement may also list specific valued collateral that the lender can go after in the event of default. This feature would be similar to non-recourse loans since the lender can only collect certain identified property to satisfy the balance. Nonetheless, it may be more than just one asset, as is typically the case with non-recourse debt.
AN EXAMPLE OF LIMITED RECOURSE LOANS
An example of a limited recourse loan agreement for a home loan might identify the home as collateral and possibly other specific assets, such as additional real estate property, vehicles, bank accounts, high-value jewelry, etc.
In the alternative, a limited recourse agreement may simply identify a specific dollar amount or percentage of the full loan amount that may be recovered in the event of default, such as 40% of the loan being collateralized. Under this arrangement, the lender can only go after assets and collateral up to that amount and nothing further.
STATES THAT BANNED RECOURSE HOME LOANS
Some states have banned recourse home loans because of the advantage they provide to lenders. In most of these states, state legislatures enacted the laws in response to the 2008 housing crisis. These states include:
- Alaska
- Arizona
- California
- Connecticut
- Idaho
- Minnesota
- North Carolina
- North Dakota
- Oregon
- Texas
- Utah
- Washington
WHAT IS NON-RECOURSE DEBT?
On the other hand, a non-recourse loan only gives the lender the right to pursue the collateral and nothing further. This essentially means the debtor is not personally liable for anything beyond the collateral in the case of a default.
For example, if a borrower defaults on a non-recourse home loan, the bank can solely foreclose on the home. Generally, the bank cannot take further legal action to collect the money owed on the debt. Whether a debt is a recourse or non-recourse may vary from state to state, depending on state law.
*TAX TIP: If the property that secured the debt was foreclosed on or abandoned, the taxpayer might need to report the sale to the Internal Revenue Service (IRS) by submitting tax form-8949, Sales and Other Dispositions of Capital Assets, in addition to Schedule D, Capital Gains and Losses. See IRS.gov and consult with a finance attorney for more information.
NON-RECOURSE “CARVEOUTS”
Under a non-recourse loan, the borrower is not personally responsible for losses the lender incurs outside of the collateral. However, this does not remain the case if the lender can prove some type of bad act has occurred, such as:
- Fraud;
- Waste;
- Intentional damage to the collateral;
- Misrepresentation;
- Environmental contamination; or
- Misapplication of the funds.
These bad acts are known as non-recourse “carveouts” and provide the lender with additional rights and options to recover their losses if a non-recourse debt agreement goes south. If a borrower under a non-recourse loan with carveouts cannot stick to the monthly payment schedule or pay off the loan at maturity, they can typically give the property back to the lender.
The benefit of this type of debt is that they will not have to repay the loan and the lender’s losses, so long as they have not committed one of the non-recourse carveouts. Keep in mind that these situations can be pretty serious and would warrant a consultation with an experienced finance attorney.
ADVANTAGES OF NON-RECOURSE DEBT
Taking on debt with non-recourse liability has several advantages for the borrower. Generally, when acquiring property subject to debt, the borrower benefits more from non-recourse debt rather than recourse because the liability risk is lower.
If a balance is due after selling the asset collateralized with the loan, the lender must take the loss. The lender has no claim on the borrower’s other funds, possessions, or income. Imagine starting up a new business and securing a non-recourse loan for the office building, start-up costs, hiring employees, and purchasing everything the company needs to get up and running. The loan might only be secured with collateral consisting of the business assets purchased with the help of the loan.
WHAT HAPPENS IF YOU DEFAULT ON A NON-RECOURSE LOAN?
If the borrower defaults on the loan, the lender will only have rights to the business assets purchased with the loan to recoup their losses. This differs from being able to collect not only the business assets but assets from the borrower personally.
DISADVANTAGES OF NON-RECOURSE DEBT
The downside is that these loans are more of a risk to the lender, so they will usually have higher interest rates or be harder to secure in the first place.
A bank or other lending institution might feel comfortable only lending money to people or businesses with 1) impeccable credit history and 2) a larger amount of capital coming into the loan agreement. This means that not everyone has access to non-recourse loans.
Further, many banks don’t offer this type of loan as a general rule because of the nature of the risk involved. The banks also consider the level of vulnerability placed on the lender.
One last thing to remember is that, although a non-recourse loan may protect your other assets, failing to pay off a non-recourse loan will be a huge hit to your credit and may take many years to bounce back from.
Questions?
If you are looking to take out either type of debt, it is important to understand 1) what type of debt is best for your needs.
Contact our firm so that we can answer any questions you might have through a free consultation.
