When you take out a loan, you are probably anticipating paying off that debt. However, sometimes things happen that are out of our control, and it may become difficult to do so. In this case, it is important to understand the difference between a recourse vs non-recourse loan, and how that will affect defaulting on the loan.
A recourse loan gives the lender the ability to seize possession of the borrowers’ assets to regain security when payments are not being made. A non-recourse loan gives the lender only possession of pre-determined collateral. While a non-recourse loan may seem like the safest option, there are many financial advantages to signing a recourse loan instead.
What is a Recourse Loan?
A recourse loan is a type of loan that allows the lender to take action in the form of collecting collateral (such as taking control of a house or car) and maybe even seizing other personal assets and finances (garnishing wages, levying accounts) when a debt is not paid back.
This gives the lender more financial security when making an investment. If there was no way to guarantee the return of the loan, lenders would incur much more risk for each loan they originate. Recourse loans are frequently seen when purchasing a car, opening a new credit card, mortgaging a house, and in hard-money loans.
The following ten states do not allow recourse mortgages:
- North Dakota
This is an ever-changing list as many states are enacting legislation that makes it difficult to precisely identify the rules revolving around recourse loans. In this case, the best thing to do is to have a full understanding of your loan and the recourse actions available to the lender.
Example of Recourse Loan
Let’s take a look at how a recourse loan can affect you. There has been an unforeseen event that causes you to default on your loan payments, here is what might happen in this situation.
You want to expand your company properties so you’ve decided to invest in the purchase of a new office building. You have taken out a $550,000 loan to purchase a $600,000 office building space. You have defaulted on the loan after making several payments on the mortgage. You still owe $510,000 on the office building property.
The lender has taken possession of the building in response to your default, but due to poor market conditions, the lender was only able to sell the office space for $500,000. The lender can now garnish your wages to secure the remaining $10,000 owed.
When a Recourse Debt is Canceled
There are three main ways to receive a cancellation of debt (COD) with regards to a recourse loan.
- Work directly with the lender. If you are unable to continue with payments on a loan, you can talk directly with the lender to discuss payment options or temporary relief the lender can offer.
- Debt relief programs. Most debt relief companies are for-profit organizations. They can act as a mediator between you and your lender to discuss lowering the amount due or other forms of relief.
- File for bankruptcy. This is a legal process that can absolve the borrower of some, or all, outstanding debt, including recourse loans.
When a recourse debt is canceled through any of the above methods, the amount forgiven is taxable as income. This means you have to declare on your taxes the exact amount forgiven and pay normal tax standards on this.
Let’s look at our previous example in some new light. To review, you took out a $30,000 loan to purchase a $35,000 car. After making some payments, you still owe $24,000 but are unable to continue with payments so the lender seizes the car. The lender could only sell the car for $19,000, taking a $5,000 loss. If you are able to get this debt canceled or forgiven, this $5,000 loss to the company now is taxable normal income for you.
What is a Non-Recourse Loan?
A non-recourse loan might be trickier to come by as it puts the lenders at more financial risk. A non-recourse loan is a loan where the lender can only seize possession of the collateral, rather than seizing additional assets and finances.
This type of loan is less common among financial institutes. Securing a non-recourse loan is more difficult because of the increased financial risk lenders will experience.
Example of a Non-Recourse Loan
Defaulting on a non-recourse loan is generally safer for the borrower since their wages and bank accounts are safe from garnishments. Here is an example of what might happen when defaulting on a single-family residential (SFR) home mortgage.
You take out a $150,000 loan on a $200,000 home. Unfortunately, circumstances have caused you to default on your payments. You and the lender were unable to communicate or work out a viable solution, so the lender has foreclosed on the property. The lender can then sell the house to redeem the initial investment. However, if the property sells for less than the value of the loan due to the poor housing market or other reasons, the lender cannot garner wages or take possession of any other assets to recover the costs.
How to Qualify For a Non-Recourse Loan? Who is Eligible?
Due to the risk placed on the lender in non-recourse loans, it is much more difficult to qualify for a non-recourse loan. Some banks do not even offer these loans as an option. In addition, during especially volatile market conditions, most lenders will not want to give non-recourse loans.
That doesn’t mean it’s impossible to acquire a non-recourse loan. Here are some key qualifications and expectations to meet to lock in a non-recourse loan:
- A higher credit score. Often the key to any loan you seek, this proves financial stability and reliance to the lender.
- A provable, steady source of income. The more money you earn, the less likely the chances of you defaulting on the loan.
- A low loan-to-value ratio. Most banks look for a 30%-40% downpayment in order to secure a non-recourse loan. This lessens the chance of a financial loss to the lender in case you default on the loan.
- A favorable Debt-Service Coverage Ratio (DSCR) Most lenders will be looking for a DSCR of at least 1.25 to qualify for a non-recourse loan.
- Accept higher interest rates. The lender might have a higher interest rate for a non-recourse loan to mitigate the risk of default and financial loss.
While a borrower never guarantees that a lender will offer a non-recourse loan, these financial characteristics will help the case and make the option slightly more appealing to the lender.
What are the Tax Implications of Non-Recourse Debt?
Non-recourse debt means that the borrower is not personally responsible for the debt, making tax implications different from that of recourse debt.
If a property is considered non-recourse debt, the amount realized is all of the non-recourse debt plus the fair market value (FMV) of the property. Unlike recourse debt, there is no ordinary income from debt cancellation of non-recourse loans. Even if the lender repossesses the property used as collateral, and sells it at a loss of the original loan amount, the borrower does not have ordinary income tax from this cancellation of debt.
Recourse vs Non-Recourse Loan
Recourse loans are far more common than non-recourse loans as they place the lender at significantly less financial risk when originating a loan. Recourse loans are generally the only loan available through banks and are very common in auto sales and home mortgages (unless you are in a non-recourse loan state).
Recourse loans only present an issue or carry any negative consequence, when a debt is not paid back. Alternatively, they can be very beneficial to the borrower in securing lower interest rates and a lower downpayment.
If you are worried about a foreclosure on your property, it’s always recommended to discuss options with your lender before missing too many payments. Taking this action before any property is seized will save a lot of trouble on both ends of the loan.