What is a recourse loan?
Key takeaways
- You are considered personally liable with recourse loans.
- Lenders can seize assets not listed in the loan agreement with a recourse loan.
- This downside may be offset — less risk for the lender often means lower interest rates.
For lenders, minimizing risk is a large part of business. It’s why bigger loans have strict requirements and why applicants who appear reliable get the best interest rates. However, some lenders may go even further in reducing risk by offering recourse loans.
Recourse loans allow the lender to seize many of the borrower’s assets if the borrower does not repay their loan — even assets that were not included in the loan agreement as collateral. It reduces risk for the lender, which means you may be able to net low rates. But since that risk may mean losing valuable assets, it is especially important that you don’t default on the loan.
How recourse loans work
When you take out a recourse loan, you agree to be personally liable if you default. A recourse loan generally refers to a type of secured loan — for example, an auto or home loan. If you take out a recourse loan and don’t repay it as promised, a lender will first seize the attached asset. In the case of a secured auto loan, this would be the vehicle you bought with the funds.
However, if the lender sells the seized asset to satisfy the debt and doesn’t receive enough cash to cover the outstanding balance of your recourse loan, it can come after other assets you own to make up the difference. For example, the company could garnish your wages or take your savings account to cover your remaining balance.
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, your lender can seize your other assets to recoup its loss. For example, let’s say you took out a car loan and stopped making payments after one year, at which point the lender seizes the car. Currently, the car is only worth $12,000 — but you still have $14,000 left on the loan.
The lender needs $2,000 to break even on the loan. If you have a recourse loan, the lender can then ask a court to garnish your wages until you’ve paid off the $2,000. It may also be able to recoup funds by taking your tax refunds, pension checks and more.
Types of recourse loans
When you take out a loan, you agree to a contract that specifies what actions the lender can take 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, there are 12 states that allow non-recourse mortgages, which means the lender will only be able to foreclose on the home — not any other assets or sources of income.
Some types of government-backed mortgages — for example, Section 232 FHA loans — are non-recourse loans, even if you don’t live in a non-recourse state. This means the lender cannot repossess any assets except for the property you bought with the loan if you default.
Recourse loan vs. non-recourse loan
In short, a recourse loan is when a lender can seize any asset, including and beyond the item used to secure the loan. By contrast, if you default on a non-recourse loan, the lender can only take the asset associated with the loan.
Because lenders face a potential loss with non-recourse loans, many do not offer them or reserve them for borrowers with the highest credit scores. They may also have a higher down payment requirement in the case of mortgages or auto loans.
Recourse loans are potentially more damaging to borrowers than non-recourse loans, but they’re also more popular with lenders. If you’re currently carrying any form of debt, there’s a good chance that it’s a recourse loan.
Should I get a recourse loan?
In general, a non-recourse loan involves less risk. But they are much more difficult to qualify for. So while your financial situation will determine which is best, in most cases, you may be unable to find a non-recourse loan.
A recourse loan is a good choice if you want to find a competitive low interest rate. They almost always come with more favorable interest rates than non-recourse loans because there is less risk for lenders 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 lending standards for non-recourse loans and mostly offer them to borrowers who have the best credit scores. You can calculate how much a lower rate will save you both monthly and overall when deciding.
The bottom line
If you already have a recourse loan, your best course of action is to pay your bills on time. If you’re worried about defaulting and have a recourse loan, you should contact your lender and ask about your options.
If you are deciding between a recourse loan and a non-recourse loan, weigh the pros and cons. You may pay more interest on a non-recourse loan, so if you have a stable job and low debt-to-income ratio, you may decide to take a small risk and choose a recourse loan.
Frequently asked questions
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The 12 states that consider mortgages non-recourse loans are:
- Alaska.
- Arizona.
- California.
- Connecticut.
- Hawaii.
- Idaho.
- Minnesota.
- North Carolina.
- North Dakota.
- Texas.
- Utah.
- Washington.
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It will depend on the laws of your state and your financial situation, but your lender may be able to garnish your wages or seize a high-value asset if you default on a recourse loan.
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Like any debt cancellation, there will be tax implications. This is especially true for secured loans like mortgages. If you are personally liable for the debt — which is the case for a recourse loan — you will need to report it on your taxes. In other cases, your tax refund could be garnished to pay back a lender if the sale of the asset wasn’t enough to cover the amount you owe.
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