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—even assets that were not included in the loan agreement as collateral. With a nonrecourse loan, the lender may only seize those assets specified in the original loan agreement as collateral.
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.
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.
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. By contrast, if you default on a nonrecourse loan, the lender can only take the asset associated with the loan. In other words, the lender may not go after any additional assets—even if the value of the asset associated with the loan does not cover the entire outstanding debt you owe. Because lenders face a potential loss with this type of loan, many do not offer them or reserve them for borrowers with the highest credit scores.
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?
Determining whether a recourse or nonrecourse loan will be best for you depends on your unique financial picture including your credit score and ability to maintain payments until the loan is fully repaid. Here are some examples of when a recourse and nonrecourse loan might be a good choice.
- You have a high debt-to-income ratio: If you’re already making significant debt payments each month or have a high debt-to-income ratio, a recourse loan will likely be a better choice. With a recourse loan, you will not risk collateral beyond that which is agreed to in the loan.
- You’re seeking a more competitive interest rate: Recourse loans almost always come with more favorable interest rates than nonrecourse loans because there is less risk for lenders in the event you are unable to repay the debt.
- You have an excellent credit score: Lenders typically have higher lending standards for nonrcourse loans and mostly offer them to borrowers who have the best credit scores. In addition, these loans may even require a larger down payment.
- You don’t mind paying higher interest: Because a nonrecourse loan limits a lender’s ability to recoup its money if you default, nonrecourse loans have much higher interest rates.
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.