Everything You Need to Know About Recourse & Non-Recourse Loans

Anyone who has ever searched for personal loans has likely come across two types of loans: unsecured and secured loans. Unsecured loans don’t require any collateral for approval, but they often come with higher interest rates because the lender takes on more risk. Secured loans use assets as collateral — with a mortgage, for example, the house is the asset that serves as collateral — which reduces the lender’s risk and often translates to lower interest rates for borrowers because lenders can recoup financial loss when they repossess the asset.

The world of secured loans, which commonly include car loans and mortgages, breaks down into two types of loans: recourse and non-recourse loans. Although both types of loans use collateral that the lender can seize if you default on your loan, these loans come with different benefits and risks. Read on to learn more about these loans and how obtaining one can affect you.

What Is a Recourse Loan?

Recourse loans are preferred among lenders because they offer less risk. These loans allow lenders to seize the asset used as collateral for the loan in addition to going after the borrower — the lender has the legal right, or recourse, to demand repayment. For example, if you have a recourse auto loan and you default, the lender can repossess the car, sell it and pursue you legally for the difference between the amount it sold the car for and the amount that you still owe on the loan. With this type of loan, lenders can sue borrowers, garnish borrowers’ wages and levy borrowers’ bank accounts to collect the amount still owed on the loan.

If you have less-than-perfect credit or you want lower interest rates, recourse loans are often your smartest bet. Because they carry less risk for lenders, banks and other lending institutions can offer the loans to individuals with imperfect credit scores at more affordable rates.

What Is a Non-Recourse Loan?

Borrowers prefer non-recourse loans, which don’t hold them personally liable for the additional funds they owe while they’re still paying off those loans. This type of loan still allows lenders to seize the assets that borrowers use as collateral for the loan, but the lenders can’t go after the borrowers for any additional funds. Using the above example, if you have a non-recourse auto loan and you default, the lender can repossess the car and sell it. The difference here is that whatever amount the lender sells the car for has to satisfy your debt. If you owe $5,000 on the vehicle and the lender sells it for $3,000, the lender has to absorb the $2,000 difference.

While borrowers aren’t held personally liable for these loans, they don’t get off without any penalties. Failing to pay a non-recourse debt in full impacts a borrower’s credit score. These types of loans also come with higher interest rates and are often available only to businesses and individuals with stellar credit.

Real World Example

To understand the difference between recourse and non-recourse loans better, consider the following examples.

Jennifer purchased her first house with a $300,000 home loan. She made timely payments until she lost her job and began struggling financially. Ultimately, Jennifer defaulted on her mortgage, and her lender placed her home in foreclosure. She still owed $250,000 on her mortgage, and the house sold for $200,000 in the foreclosure sale. Because she had a recourse loan, Jennifer’s lender was able to sue her for the difference between what she owed on the loan ($250,000) and the amount that the lender recouped during the foreclosure ($200,000). Her wages were garnished and she was forced to continue paying off the $50,000 until the debt was fulfilled.

Robert also purchased his home with a $300,000 mortgage. He successfully managed his finances for several years before falling ill and retiring early from his job. With his reduced monthly income barely covering his mounting medical bills and debt, he fell behind on his mortgage payments and eventually ended up in foreclosure still owing $250,000 on his house. Like Jennifer, his home sold for $200,000, but because he had a non-recourse loan, the bank accepted the $200,000 and was unable to pursue the $50,000 difference.

Recourse and Non-Recourse Loans: Tax Implications

The type of loan you have also affects the taxes that you ultimately have to pay after the lender seizes and sells the asset you used to secure the loan. For recourse loans, taxpayers are treated as if they sold the recouped property to the lender at fair market value. If the lender forgives the amount that the borrower owes beyond the fair market value, that amount is treated as a cancellation of debt, which the Internal Revenue Service (IRS) can then tax. For non-recourse loans, debtors are treated as if they sold the asset for the outstanding balance on the loan.

To get a better idea about the tax implications of these loans, revisit the examples of Jennifer and Robert and assume that the fair market value of each property was $200,000. Because Jennifer had a recourse loan, the selling price of her home for tax purposes was $200,000. Because Robert had a non-recourse loan, the selling price was the balance of what he owed: $250,000.

Recourse and Non-Recourse Loans: State Laws

Whether you have a recourse or non-recourse loan depends largely on state law. If you’re unsure of your loan type, research your state to determine its laws regarding these loans and how impending foreclosures or asset seizures affect you. Non-recourse states include Alaska, Arizona, Washington, Utah, Idaho, Minnesota, California, North Carolina, Connecticut, North Dakota, Texas and Oregon. These states only allow non-recourse loans.

In other states, you may have either type of loan. If you have a recourse loan, the state allows your lender to pursue a deficiency judgement to recoup its money. Most states restrict a lender’s ability to pursue a deficiency judgement beyond the fair market value of the asset.

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Published September 9, 2016
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