For lenders, minimizing risk is a crucial aspect of business. This is why larger loans come with stringent requirements and why applicants with reliable profiles receive the best interest rates. To further mitigate risk, some lenders offer recourse loans.
Recourse loans grant the lender the authority to seize multiple assets from the borrower if the loan is not repaid, including assets not initially listed as collateral in the loan agreement. This significantly reduces the lender’s risk, potentially resulting in lower interest rates for the borrower. However, since defaulting on the loan could lead to the loss of valuable assets, it is imperative to ensure you can meet the repayment obligations.
How recourse loans work
When you take out a recourse loan, you agree to be personally liable if you default. Typically, a recourse loan refers to a type of secured loan, such as an auto or home loan. If you fail to repay a recourse loan as agreed, the lender will first seize the asset tied to the loan. For instance, in the case of a secured auto loan, this would be the vehicle purchased with the loan funds.
However, if the lender sells the seized asset and the proceeds are insufficient to cover the outstanding balance of your recourse loan, the lender can pursue other assets you own to recover the remaining debt. This could include garnishing your wages or taking funds from your savings account to cover the deficit.
An example of a recourse loan
Let’s say you take out an auto loan to buy a car. If you stop making payments, the lender can legally repossess the vehicle.
If the vehicle’s value is less than the remaining loan balance, the lender can seize your other assets to recoup its loss. For instance, if you default on the loan after one year and the lender repossesses the car, the car might now be worth only $12,000, but you still owe $14,000 on the loan.
To cover the $2,000 shortfall, the lender can seek a court order to garnish your wages if you have a recourse loan. Additionally, the lender may recover funds from your tax refunds, pension checks, and other sources until the debt is settled.
Types of recourse loans
When you take out a loan, you agree to a contract specifying the lender’s actions if you default. Auto loans, credit cards, short-term real estate loans, and some personal loans are all considered recourse loans.
Most mortgages are also recourse loans. However, 12 states permit non-recourse mortgages, meaning the lender can only foreclose on the home and not pursue other assets or income sources.
Some government-backed mortgages, such as Section 232 FHA loans, are non-recourse loans even if you don’t live in a non-recourse state. This means that if you default, the lender can only repossess the property purchased with the loan and cannot seize any other assets.
Recourse loan vs. non-recourse loan
In short, a recourse loan allows a lender to seize any asset, including those beyond the collateral securing the loan. In contrast, with a non-recourse loan, if you default, the lender can only take the specific asset associated with the loan.
Due to the higher risk of loss, many lenders do not offer non-recourse loans or reserve them for borrowers with the highest credit scores. Non-recourse loans, such as mortgages or auto loans, often require a higher down payment.
Recourse loans pose a greater risk to borrowers but are more favored by lenders. If you currently have any form of debt, it is likely a recourse loan.
Should I get a recourse loan?
In general, a non-recourse loan involves less risk but is much more difficult to qualify for. Your financial situation will largely determine which option is best, but finding a non-recourse loan may be challenging.
A recourse loan is a good choice if you want a competitive interest rate. They almost always offer more favorable rates than non-recourse loans because the lender faces less risk if you are unable to repay your debt.
A non-recourse loan is best if you have an excellent credit score. Lenders typically have higher standards for non-recourse loans and usually offer them to borrowers with the best credit scores. When deciding, consider how much a lower rate will save you both monthly and overall.
In Conclusion
If you already have a recourse loan, the best approach is to ensure timely bill payments. If you’re concerned about defaulting, contact your lender to discuss available options.
When deciding between a recourse and a non-recourse loan, weigh the pros and cons carefully. A non-recourse loan might come with higher interest rates, so if you have a stable job and a low debt-to-income ratio, you might consider taking the calculated risk of choosing a recourse loan.