For lenders, minimizing risk is the name of the game. That’s why bigger loans have more stringent qualification requirements and why only the most reliable borrowers get the best interest rates. However, some lenders may go even further in reducing risk, offering what’s known as recourse loans.
Recourse loans are loans that allow the lender to seize many of the borrower’s assets if the borrower fails to repay their loan. Here’s what you should know about the difference between recourse and nonrecourse loans and what it means for borrowers.
Types of recourse loans
A recourse loan is when the lender is able to seize assets beyond the original collateral used to secure the loan. When you take out a loan, you agree to a contract that specifies what actions the lender can take if you default. Some common types of recourse loans include:
Most mortgages are also recourse loans, but there are 12 states that allow nonrecourse mortgages. If a borrower defaults on a mortgage in one of those states, the lender will only be able to repossess the home and not any other assets or sources of income.
These states are:
- North Carolina.
- North Dakota.
All government-backed mortgages are nonrecourse loans, even if you don’t live in one of the 12 states listed above. If you default on a VA, USDA or FHA loan, the lender cannot come after any assets except for your home.
Recourse loan example
Let’s say you take out an auto loan to buy a car. Whether or not you have a recourse loan, the lender can legally repossess the vehicle if you stop making payments.
The recourse aspect kicks in if the value of the vehicle is less than the remaining balance on the loan. 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. At this time, the car is only worth $12,000 — but you still have $14,000 left on the loan.
The lender needs to recoup $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, Social Security checks and more.
Recourse loan vs. nonrecourse loan
In short, a recourse loan is when a lender can seize any asset, including and beyond the item used to secure the loan. With a nonrecourse loan, the lender can only take the asset associated with the loan.
Recourse loans are potentially more damaging to borrowers than nonrecourse 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?
There are a few things to consider if you have the option of choosing between a recourse loan and a nonrecourse loan. First, interest rates on recourse loans are almost always lower than those of nonrecourse loans, because the lender is taking less of a risk that it’ll lose money on the agreement.
Lenders also have higher lending standards with nonrecourse loans. They may require a larger down payment or better credit score.
“In some cases, you can’t get a Ioan unless it is recourse — such as when you borrow money to start a business,” says Leo Marte, CFP, MBA of Abundant Advisors. “Lending institutions know that the business has a high chance of default, so there is a recourse clause to come after the assets of the owner in case of default.”
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 call the lender and ask about your options.
If you are deciding between a recourse loan and a nonrecourse loan, weigh the pros and cons. You may pay more interest on a nonrecourse 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.