What are Recourse and Nonrecourse Loans?

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Definition:

Recourse and nonrecourse are two different types of loans that differ based on the rights of lenders to recover their money.

🤔 Understanding the difference between recourse and non-recourse loans

When you enter a loan contract, you have an obligation to pay back what you borrowed, while your lender has the right to recover its money. Different types of loans give lenders different means of getting their money back. Recourse and nonrecourse loans both allow creditors to take any collateral, which is an asset that borrowers agree to hand over to the lender if they default on a loan. For nonrecourse loans, lenders can’t take any further action. Recourse loans, on the other hand, enable creditors to attempt to recover more money if the amount the borrower owes exceeds what the collateral is worth.

Example

Suppose Susan’s employer recently let her go from her job due to downsizing. Unfortunately, Susan now has monthly bills that she can no longer pay. Her creditors start contacting her, trying to recoup their losses. Because Susan has stopped making her mortgage payments, the lender forecloses on her home. Mortgages are generally non-recourse loans, meaning if the bank can’t sell the house for enough to cover the debt, it will have to take the loss. It can’t come after Susan for more money. Susan also owes money on her car. Because auto loans are often recourse loans, Susan’s lender auto lender has more rights. If it can’t get back all of its money selling the car, it can try other ways of recovering its loss, such as asking a judge to garnish Susan’s future wages.

Takeaway

Recourse and nonrecourse loans are like the difference between the owner and the cashier of a store…

Both the owner and the cashier at your local market have a stake in keeping the business running well, and both can lose money if things go downhill. But ultimately only one of those people is truly responsible for the outcome, and can lose a lot more money. Similarly, recourse and nonrecourse loans place different levels of responsibility on lenders and borrowers. Just as the owner of the store is ultimately left holding the bag if the store goes out of business, the lender of a nonrecourse loan has no further recourse if selling the loan collateral doesn’t cover the bill.

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What are recourse and nonrecourse loans?

Recourse and nonrecourse loans are two types of loans you might get from a creditor. The two types of loans differ primarily based on which party is personally liable for the debt if the borrower defaults on the loan. In the case of recourse loans, the borrower must always make the lender whole. If the borrower defaults on the loan, the lender can take further action to get their money back. In the case of nonrecourse loans, lenders may be in a position where they can’t fully recover their losses.

What is a recourse loan?

In the case of a recourse loan, a lender has a right to recover all of their losses. If a borrower stops making payments, a lender can seize any collateral (meaning an asset the borrower agrees to hand over in the case of default) in the loan agreement. But there could be situations where the value of the collateral isn’t enough to cover the debt.

A common example of this situation might be when you borrow money to buy a car. Because cars lose their value, you may end up owing more on your car than it’s worth. So, what happens if a lender takes the car, sells it, and it doesn’t cover the debt? In that case, a recourse loan allows the lender to take further legal action against the borrower. The lender might take you to court, where a judge may order wage garnishments or a lien on another asset you own.

What is a nonrecourse loan?

A nonrecourse loan is one that gives the lender fewer options to recover their losses if the borrower stops making payments. Suppose you have a home loan that’s a nonrecourse debt. If you fail to make your mortgage payments, the bank might foreclose on your house. But what if the sale of the house isn’t enough to cover the rest of the nonrecourse mortgage debt? In the case of a nonrecourse loan, the lender can’t take further legal action after seizing the collateral and has to take the loss.

What are the differences between recourse vs. nonrecourse loans?

The difference between recourse and nonrecourse loans comes down to who bears the greatest amount of liability (aka responsibility) for the debt if the borrower defaults. When you sign a loan agreement, you’ve entered into a contractual agreement with another party (likely a financial institution of some kind). It’s your responsibility to pay back that loan. If for some reason you can’t make your payments and you default on the loan, someone has to be responsible for what’s left. Depending on the type of loan you have, it’s either you or your lender.

With a recourse loan, you’re fully liable for the amount you owe the lender, and your lender has the right to recover all of its money. With a secured loan (meaning one backed by an asset), the lender can start by seizing your collateral. But if the value of that asset isn’t enough to cover the full value of the loan, the lender can take extra steps. Recourse loans also often involve no collateral at all, as is the case with credit cards.

For nonrecourse loans, the lender takes on more of the liability. As with a recourse loan, lenders can seize a borrower’s collateral if that borrower stops making his or her loan payments. But other than that, there isn’t much the lenders can do. They’re liable for the remainder of the debt.

Are you required to repay a nonrecourse loan?

When you sign a loan document, you’re taking on the legal obligation of paying back your debts. And while a lender in a nonrecourse loan may only be able to collect collateral listed in the loan agreement if you stop making payments, there are certainly consequences if you don’t pay.

First, a nonrecourse mortgage allows the lender to foreclose on your house. As a result, you may end up losing any equity you’ve already built in the house. On top of that, you lose your home and have to assume the costs of finding somewhere else to live.

There are also serious implications for your financial future. Depending on your current credit score, a foreclosure can reduce it by anywhere from 100 to 160 points. For the next seven years, lenders will see this incident on your credit report, which will probably make it challenging for you to get another loan in the future. This doesn’t apply to just your next mortgage — You might also struggle to get a car loan, a credit card, or even to rent an apartment.

There can also be tax consequences in a foreclosure. When your bank forecloses on your house and gets rid of the mortgage debt, the Internal Revenue Service (IRS) generally considers this to be a cancellation of debt. Cancellation of debt in many casses is income in the eyes of the IRS, and you’ll have to pay taxes on that amount.

Are mortgages recourse or nonrecourse loans?

Federal law gives guidance on the difference between recourse and nonrecourse loans and what happens if you default on each. But it doesn’t necessarily say which type of debts should be recourse and which should be nonrecourse. Depending on where you live, your mortgage may or may not be a recourse loan. There are no federal laws dictating whether mortgage loans must count as nonrecourse debt. Instead, most states have taken action to fully or partially limit a lender’s ability to treat a mortgage as a recourse loan.

Which states only allow nonrecourse loans?

Twelve states have passed laws prohibiting lenders from making deficiency claims after a foreclosure. A deficiency claim is when the lender sells the home for less than the value of the mortgage and attempts to recover the rest from the borrower. Basically a deficiency claim is a lender going after recourse.

These are the 12 states that, as of July 2020, only allow nonrecourse loans:

  • Alaska
  • Arizona
  • California
  • Connecticut
  • Idaho
  • Minnesota
  • North Carolina
  • North Dakota
  • Oregon
  • Texas
  • Utah
  • Washington

Does nonrecourse give a partner basis?

Basis refers to the amount of money that an individual in a business partnership has in the company. A partner’s basis increases when that person contributes money into the business or when the business’s income increases. A partner’s basis decreases when the company takes a loss, or when that partner takes a distribution.

So what does this have to do with recourse and nonrecourse debt? Just like consumers take on debt, so do businesses. For a nonrecourse loan, the partners aren’t generally personally liable for the debt. Instead, they’re each liable for up to the amount of money they have in the business. When a company takes on more debt, each partner’s share of the debt is considered a contribution of money to the partnership. The nonrecourse loan increases a partner’s basis by his or her share of the debt.

When can a nonrecourse loan become full recourse?

Nonrecourse loans place the bulk of liability on the lender. If the borrower defaults, there’s only so much the lender can do to recover its money. Nonrecourse loans are riskier for lenders than recourse loans. Lenders may place provisions in a real estate loan agreement to call out certain situations where a nonrecourse loan becomes a recourse loan. These provisions, also known as bad boy guarantees, include fraud and certain bankruptcy actions.

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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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