Recourse Loans and Non-recourse Loans
After Lenders take Collateral, What Next?
When you borrow money, it's important to understand what's at stake. What happens if you fail to repay the loan?
With a recourse loan (or recourse debt), you are personally liable for any unpaid debt, and the lender can take action to collect – even after seizing collateral. With a non-recourse loan, by contrast, the lender does not have as many options, so the bank is taking more risk.
Collateral and Sales Proceeds
With any loan agreement, you agree to repay according to a specified schedule.
For example, a home loan has monthly payments that often last 15 or 30 years. If you stop making payments, you eventually default on the loan. Depending on your loan (and state law), lenders might have several options for collecting on an unpaid loan balance.
Take collateral: if you used collateral to get approved, lenders can almost always take the collateral, sell it, and use the proceeds to pay themselves back. Common examples of this action include foreclosure with home loans and repossession for unpaid auto loans.
Deficiency: unfortunately, collateral doesn’t always pay off your entire loan balance. In a foreclosure, the property might be worth less than the total loan balance, especially if the housing market has weakened since the loan was made (known as being underwater or upside-down). Any remaining unpaid balance – which might include fees and charges associated with foreclosure or repossession – is a deficiency balance.
Whether or not the lender can continue efforts to collect the deficiency depends on whether or not the loan is a recourse loan.
No recourse: if the debt is not recourse debt, the lender is out of luck. Any deficiency balance must be absorbed by the lender (taken as a loss). As a result, non-recourse loans are the riskiest types of loans for lenders.
Banks still offer plenty of non-recourse loans, but they try to manage their risk. For example, you might need to have higher credit scores to qualify for non-recourse loans, or lenders might require lower loan to value ratios to protect themselves.
If a loan is a recourse loan, lenders can continue to try and collect after taking collateral. A creditor can win a deficiency judgment, which is a legal action allowing them to take other legal actions. Typical activities include:
- Collections: the lender might contact you asking for money, or the lender may sell the debt to a collection agency that will try to collect
- Garnishment: the lender or a collection agency may get the right to take money out of your pay (your employer must pay the creditor) until your debt is repaid
- Levies: creditors can take assets that were never pledged as collateral in some cases. For example, creditors might be able to take money from your bank account or get an interest in property that you own.
These collection efforts have limits, so speak with a local attorney if lenders are trying to collect on a deficiency. For example, creditors can only take a portion of your pay, and that portion depends on your financial circumstances – don’t let them take too much.
Likewise, creditors can’t always take money out of your bank account – you can appeal and limit how much is available to them.
Identifying Loan Types
Meet with a local attorney or tax adviser to be certain whether you have a recourse loan or a non-recourse loan. However, you can use the information below for discussion.
State laws often dictate whether a loan is a recourse loan or not. California is best known as a non-recourse loan state that makes it hard for lenders to sue. Some states give lenders flexibility in how they pursue defaults, but many lenders choose not to sue because defaulting borrowers often don’t have much to sue for.
Purchase loans for your primary residence are most likely non-recourse loans in non-recourse states.
Refinances, second mortgages, and "cash out" transactions tend to create recourse loans (even if you previously had a non-recourse loan).
In other words, you might buy a home and the initial loan is not recourse debt – but any additional loans you get using the same collateral are recourse loans.
Recourse Loans and Taxes
In the event of default, your tax liability may depend on whether or not you have a recourse loan. Our tax expert discusses these issues in his article: Foreclosures and Taxes. Again, it’s crucial to speak with a local tax advisor before filing so that you get all of the details right.
Non-recourse debt is good news when it comes to limiting actions that creditors can take. Unfortunately, you might get an unexpected tax bill as a result of unpaid debt.