When you borrow money, it's crucial to understand the potential risks. What happens if you fail to repay the loan?
With a recourse loan (or recourse debt), you are personally liable for any unpaid debt. Perhaps most importantly, the lender can take action to collect any unpaid balance—even after seizing collateral. With a non-recourse loan, by contrast, the lender does not have as many options, so the bank takes more risk.
Collateral and Sales Proceeds
With most loan contracts, you agree to pay off the debt according to a specified payment 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 often take the collateral, sell it, and use the proceeds to pay themselves back. Common examples 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. That can happen when the housing market weakens after you borrow money to buy (sometimes 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 (or taken as a loss). As a result, non-recourse loans are the riskiest types of loans for lenders. Banks still offer non-recourse loans, but they try to manage their risk before approving loans. 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 try to collect an unpaid balance after taking collateral. A creditor can win a deficiency judgment, which is a legal action allowing them to take additional 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 the property that you own.
There are limits on what steps lenders can take, so speak with an attorney licensed to practice in your area if you face a deficiency judgment. For example, creditors can typically 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 may be able to appeal through the legal system and limit how much is available to your creditors.
Identifying Loan Types
Meet with an attorney or tax adviser to verify if you have a recourse loan or a non-recourse loan. You can use the information below for discussion:
- State laws: These 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 lenders might choose not to sue because defaulting borrowers often don’t have funds available to pay off the debt.
- Purchase loans: If you borrow for your primary residence, these are most likely non-recourse loans in non-recourse states.
- Refinances: Second mortgages and "cash-out" transactions can 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 could be recourse loans.
Recourse Loans and Taxes
If you default on a loan, your tax liability may depend on the status of your loan. Non-recourse debt could be favorable when it comes to limiting actions creditors can take. Unfortunately, you might get an unexpected tax bill as a result of unpaid debt.
It’s crucial to speak with a local tax adviser before making any decisions or filing a return.