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.
But there’s also something else you should think about: 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 Is A Nonrecourse Loan?
To start, a nonrecourse mortgage loan favors the borrower because it assures the borrower loses only their collateral and will never owe more on their loan than the asset is worth. This means that if you fail to pay your mortgage and the lender forecloses on your home, that’s all they can do. If the lender sells the foreclosed property 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.
Whether a loan is a nonrecourse loan may depend on state laws. There are 12 states that, by law, only allow nonrecourse loans. These are known as “nonrecourse states,” and they include Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah and Washington.
It could also depend on the type of loan. For example, most reverse mortgages are nonrecourse loans, while most auto loans are not.
Understanding Nonrecourse Debt
Nonrecourse debt is debt that’s secured by collateral, which is the only asset a lender can take if you default on the debt. The lender can only use that collateral to cover the amount of debt owed. If the collateral doesn’t cover the amount of debt, the lender cannot seize any other property or money from you.
Nonrecourse doesn’t get you off the hook for paying back your debts. As a borrower, you’re responsible for paying back your loan. If you don’t, you’ll still lose that asset, the default will be on your record and your credit will be negatively affected.
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.
The same goes for another common recourse loan, your car loan. These types of loans are typically recourse loans because car values are notorious for dropping as soon as you drive away from the dealership. Let’s say you get a car loan for $20,000 to purchase a car. As you drive the car, the value drops more and more. After a year of owning the car, you stop making payments, but you still owe $16,400 on the loan. The lender seizes the car, but by now the car is only worth $14,000. Because the loan is a recourse loan, the lender can sue you for the additional $2,400 to cover the debt owed.
In some situations, rather than pursuing legal action, a lender may forgive the debt that isn’t covered by the collateral. For example, a lender may agree to a short sale or deed in lieu of foreclosure, which helps them avoid the long and costly process of foreclosure.
In a short sale, you’d put the home up for sale and the lender would choose which offer to accept, agree to take that sale price as the loan payoff amount and absorb the rest of what’s owed.
With a deed in lieu of foreclosure, you’ll sign your home over to the lender instead of the lender foreclosing on the home. With this voluntary act, the lender agrees to forgive any remaining balance after the home is sold.
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.
Recourse Vs. Nonrecourse Loans: Key Differences
The main difference between recourse and nonrecourse loans has to do with which assets of yours a lender can take if you (the borrower) can’t repay the 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. If your mortgage is a nonrecourse loan, nothing will happen after the lender seizes the home. If the home sells for less than what is owed, the lender will absorb the difference. If the mortgage is a recourse loan and the home sells for less than what is owed, the lender could attempt to collect the difference by garnishing your wages or charging your bank account.
There are other factors that distinguish recourse loans from nonrecourse loans. It’s important to consider these when choosing what loan is right for you. These factors include:
- Nonrecourse loans are favored by borrowers, while recourse loans are favored by lenders.
- Nonrecourse loans are riskier for the lender. Recourse loans are riskier for the borrower.
- Since recourse loans are less risky for lenders, they often come with lower interest rates. Nonrecourse loans typically have higher interest rates.
- Nonrecourse loans are typically offered more to borrowers who have great credit and are in good financial standing.
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.
It’s also important to 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).
There are no tax implications if you have a nonrecourse loan. But with 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. That’s because when you borrowed the money, you were required to pay it back, so it wasn’t seen as income. Now that you aren’t required to pay it back, it could be seen as income.
Not all debt cancellations are taxable. According to IRS tax guidelines, debt cancellation due to bankruptcy, insolvency and on certain farm debts may be exceptions to the rule.
Which Loan Option Is Best For You?
Each loan has its benefits and drawbacks, and just like any important decision, it’s best to compare the pros and cons to determine the best loan option for you.
A Nonrecourse Loan Is Right For You If…
The best reason for choosing a nonrecourse loan is that it favors you, the borrower, and helps protect your other assets should you default on your loan. While you should never get a loan if you think you’ll default, a nonrecourse loan is less risky than a recourse loan. However, because of this, you may pay a higher interest rate.
A Recourse Loan Is Right For You If …
You should choose a recourse loan if you have stable income and the risk of defaulting on your loan is very low. It’s also a good option if you’re looking for a lower interest rate than what a nonrecourse loan may offer. Of course, sometimes, it may be your only option – as is the case for most car loans.
The Bottom Line
With a nonrecourse loan, you’ll never owe more than your collateral is worth. This type of loan helps protect you from losing other assets should you default on your loan. For example, if you default on a mortgage that’s a nonrecourse loan, the lender may take the home, but cannot come seize any other assets or come after more money if the value of the home is lower than what you owe on the loan.
When it comes to recourse loans, the lender can come after other assets to make up the difference between the value of your collateral and what’s owed. In some instances, the lender may forgive that debt.
When it comes to choosing between the different types of home loans available, make sure you make an educated decision. Learn more about each loan and weigh the pros and cons to see which will offer the most benefits for you based on your financial goals.