When shopping for a mortgage, there are many factors to consider, including your comfort level with the lender, if the lender services the loan, the amount you can afford and the interest rate.
There’s another factor to consider: Is it a recourse or nonrecourse loan? Once you know the difference and which one you have, what are the other implications? Let’s dig in.
What Are the Differences Between Recourse and Nonrecourse Loans?
The difference between recourse and nonrecourse has to do with which assets of yours a lender can take if you (the borrower) can’t repay a loan. Regardless of which type of loan you have, if you fail to pay off your loan, anything that was used as collateral on the loan can be taken by the lender. In the case of mortgages, this collateral would be the home you needed the loan for in the first place. The lender will seize the house, sell it and pay off what you defaulted on. The difference of what happens (if anything) after that separates recourse from nonrecourse.
Being a mortgage lender, we’re going to frame these implications of what it means in terms of your home, but these guidelines could just as easily apply to your car or any other piece of real property you might own.
What Is a Nonrecourse Loan?
To start, a nonrecourse bank loan favors the borrower because it assures the borrower loses only their collateral. This means that if you fail to pay your mortgage and the lender forecloses on your home, that’s all they can do. So, if the lender sells the house and doesn’t make their money back on the defaulted amount, it’s their loss; no legal action can be taken against you for those lost funds.
Reverse mortgages are one popular financial instrument that is generally a nonrecourse loan.
What Is a Recourse Loan?
A recourse loan favors the lender because it allows them to pursue legal action even after the collateral (e.g., your home) has been seized. Remember how with a nonrecourse loan, the lender can lose money after selling your foreclosed house? Well, if it’s a recourse loan, the lender can garnish your wages or pursue legal action to levy your bank account to make up for the amount they lost after calculating the amount recouped from selling your home.
How Do I Find Out if I Have a Recourse Loan?
This depends on state law. Some states have specific nonrecourse provisions. However, this also depends on how a lender chooses to foreclose your property. It can be done in or outside of court (known as judicial or nonjudicial foreclosure), and the variables that happen from there get even more varied.
You can research online for your state and see where the state laws fall on whether your loan is recourse or nonrecourse and how that can change with impending foreclosure. You may also be able to review your mortgage agreement or ask your lender.
If you’re facing foreclosure, make sure that you contact a professional in the matter.
Other Implications for Recourse and Nonrecourse Loans
Beside the repossession of your property and the remedies a lender has in order to recover their financial loss, there are a couple of other factors in the differences in loan types.
Interest rates are generally higher with a nonrecourse loan than with a recourse loan. The reasoning for this is that there’s a higher risk to the lender on a nonrecourse because they can’t seize other assets you have if your home doesn’t sell for at least the outstanding loan balance. With this higher risk comes a higher interest rate.
I want to also note that a recourse option might be the only way to get a loan if you have a lower credit score or a higher debt-to-income ratio (DTI).
On recourse loans, if your debt is canceled by the lender following a foreclosure (meaning you don’t have to pay off a certain portion of the debt), you may be required to claim the portion of the debt that has been forgiven as income on your taxes.
The IRS has guidelines, and there are various stipulations to this, so you should definitely speak with your tax advisor. However, there are no tax implications if you have a nonrecourse loan.