Recourse Vs. Nonrecourse Loans: What’s The Difference?
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?
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.
What Is 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? With 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.
Another common example of a recourse loan is 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.
Can Lenders Forgive Recourse Debt?
In some situations, rather than pursuing legal action, a lender may forgive a portion of 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 Whether I Have A Recourse Or Nonrecourse Loan?
There are a variety of situations that can determine your loan’s terms. To know where you stand, look over your mortgage note. All the terms of your mortgage are included in that document. If you’re facing foreclosure, contact an attorney or legal service for help.
Whether a loan is a nonrecourse loan generally depends on the laws of the state where the loan originates. 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.
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.
Type Of Loan
Some types of home loans are nonrecourse by definition. For example, most reverse mortgages are nonrecourse loans, because financial products targeted at seniors are often afforded greater consumer protection.
A borrower with near-perfect credit might be able to negotiate with their lender to include a nonrecourse clause at no additional cost while shopping for a mortgage. All others would have to be willing to pay a higher interest rate for a nonrecourse loan.
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.
But 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’re usually offered at 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 riskier to lenders than a recourse loan. Because of this, you’ll generally pay a higher interest rate for a nonrecourse loan.
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, unless your property is located in a nonrecourse state.
The Bottom Line: It’s Important To Understand Your Mortgage Contract
With a nonrecourse loan, you’ll never owe more than your collateral is worth. That offers borrowers peace of mind. Learn more about how to stop a foreclosure on your home.