When borrowing money, it’s important to understand your obligations for paying it back and what can happen if you default. Specifically, it’s necessary to know the difference between recourse vs. nonrecourse loans.
Whether a debt is considered recourse or nonrecourse can vary from state to state and the type of debt involved. Before borrowing money, it’s helpful to know more about what distinguishes nonrecourse financing from other types of loans.
Recourse Loans vs. Non-Recourse Loan: What’s the Difference?
Both recourse and nonrecourse debt can be secured by collateral, which a lender can seize in the event of non-payment.
The biggest difference between the two is that the lender is prevented from pursuing other assets owned by the borrower to repay what’s owed on a nonrecourse debt. Basically, the lender has no other recourse for repayment of the debt other than the collateral that secures the loan.
When a borrower defaults on a recourse debt, the lender can seize not only the loan’s collateral, but can also attempt to attach other assets to collect what’s owed. In essence, the lender has additional recourse to recoup their losses.
Between recourse vs. nonrecourse debt, recourse debt favors the lender while nonrecourse debt favors the borrower.
Mortgages are typically classified as nonrecourse debt. The determination is usually made by the lender, but 12 states consider home mortgages to be nonrecourse loans , as a matter of law, meaning the lender cannot pursue a borrower’s other assets if they default and end up in foreclosure. The financial consequences would likely be limited to loss of the home and damage to the borrower’s credit score.
The original loan documents should state if it’s a recourse or nonrecourse loan. The lender will also be able to state which type of loan it is.
Which Is Better: Recourse vs. Nonrecourse Debt?
The answer to this depends on whose perspective the situation is being viewed from. Recourse debt is always more favorable to the lender. That’s because this type of debt gives the lender more freedom to collect when a debt goes unpaid.
For example, a borrower takes out a $25,000 car loan to purchase a new vehicle. They lose their job and now can’t keep up with the payments. After the borrower defaults on the loan, the lender can repossess the car. But there’s a problem. The borrower still owes $20,000 on the loan, but the car is only worth $15,000.
In that scenario, the lender can take further action to make up the difference between what’s owed and the vehicle’s value. Again, that usually means the lender filing a lawsuit to win a civil judgment. If this is successful, the lender can then seek to attach the borrower’s other assets.
With a nonrecourse loan, the terms are more favorable to the borrower if they default. Going back to the previous example, if the car loan was a nonrecourse loan, the lender could repossess the vehicle but they couldn’t lay claim to any of the borrower’s other assets.
But there’s a potential downside. Nonrecourse financing is usually riskier for the lender, since they’re limited to collecting only the collateral when a borrower defaults. As such, lenders may charge higher interest rates for nonrecourse loans and/or require borrowers to meet higher credit score and income requirements to qualify.
Recourse loans, on the other hand, may be easier to get since they pose less risk for lenders.
How to Manage Recourse vs. Nonrecourse Loans
Generally, the only reason for a borrower to be concerned about whether they have recourse vs. nonrecourse debt is if they’re in danger of default. As long as they’re keeping up with their payments, whether a debt is recourse or nonrecourse shouldn’t be an issue.
But if there is a concern about potentially falling behind in paying a debt, then it helps to do some research before borrowing. For example, if trying to qualify for a home loan, asking upfront whether the loan is treated as a recourse or nonrecourse debt under a particular state’s laws will help in the decision making.
Making a larger down payment, for example, means less a borrower has to finance. Ultimately, though, a borrower should do what is right for their particular financial situation. It may be better to choose a home loan that allows for a lower down payment so they can keep more cash in the bank to cover financial emergencies down the line.
If planning to apply for a car loan, a person may consider buying a vehicle that tends to hold its value longer or making a larger down payment. Those could both help a borrower avoid ending up underwater on the loan if they happen to default for any reason.
Credit cards are revolving debt, not a one-time amount of money being borrowed, so the amount owed can change month to month as purchases are made and paid off. Some ways to manage this type of recourse debt include:
• Keeping card balances low.
• Paying the balance in full each month, if possible.
• Setting up automatic payments or payment alerts as notification of when a due date is approaching.
With any type of debt, recourse, or nonrecourse, it’s important that the borrower gets in touch with the lender or creditor as soon as they think they’ll have trouble making payments. The lender may be able to offer options to help manage payments temporarily. Depending on the type of debt, that may include:
Reaching out before a payment is missed can help avoid loss of assets and it can help prevent negative credit score impacts as well.
If you’re having trouble juggling multiple debts, consolidating them will help streamline your monthly payments to help make them easier to manage.
SoFi offers unsecured personal loans from $5,000 to $100,000 that can be used for debt consolidation. There are no prepayment fees, no origination fees, and no late fees. Checking your rates takes just 1 minute, with no commitment.
There’s no collateral needed, and since interest rates are fixed, your monthly payments are predictable.
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