Are your assets at risk when you enter into a mortgage to buy a home? If your loan is a recourse loan, the bank can take the collateral used to secure the loan (the real estate, for example) as well as your assets if you default on the loan. If your mortgage is a non-recourse loan, the bank is limited to the collateral used to secure the loan. Each type of loan is unique and understanding the difference can help you find the right loan and save you a lot of money.
Written by Attorney William A. McCarthy.
Updated October 6, 2021
Are your assets at risk when you enter into a mortgage to buy a home? If you’re a homeowner, even if you don’t plan to walk away from your mortgage, it’s important to know the answer. It depends on whether the loan is recourse or non-recourse. If your loan is a recourse loan, the bank can take the collateral used to secure the loan (the real estate, for example) as well as your assets if you default on the loan. If your mortgage is a non-recourse loan, the bank is limited to the collateral used to secure the loan. It can’t take your other personal assets.
Each type of loan is unique and understanding the difference can help you find the right loan and save you a lot of money.
A recourse loan is a form of secured financing that gives a lender the legal right to go after your assets. If a borrower defaults on a recourse loan, the lender will first take the collateral to try to pay off the unpaid loan balance. If that doesn’t cover the outstanding debt, the lender has the legal ability — also called the recourse — to go after the borrower’s other assets. This is sometimes referred to as a full-recourse loan.
Collateral is an asset identified in a loan agreement that the lender can take if the borrower defaults. The collateral for a home loan is generally the home or real property. The lender may identify additional assets that can be seized in the loan agreement, including bank accounts and income sources. Recourse loans don’t always specify what collateral or other assets secure the loan, but they do allow a lender to go after other assets in the event of default.
What happens if the value of the home isn’t enough to satisfy the outstanding loan balance? If the loan agreement doesn’t identify other forms of security, the lender may have to go to court and get a court order called a judgment before seizing other assets. This might include garnishing wages, levying bank accounts, and forcing a sale of other assets. When it comes to default judgments, rights vary from state to state.
To understand the many types of recourse loans, you need to understand secured debt. Home loans, car loans, and hard money loans — short-term loans used for purchasing investment or commercial real estate — are all recourse loans. A loan to purchase a home is referred to as a mortgage. Mortgages are always secured by the property. Some mortgages are recourse loans, which allow the lender to pursue the borrower’s assets if they default.
Recourse Loans Are Less Risky for Lenders
Lenders generally prefer recourse loans because they are less risky when there’s a default. They can sue the borrower if the value of the collateral is less than the unpaid loan amount and get a court order to collect directly from the borrower. This may allow them to collect the full amount due on the loan.
For example, assume a borrower owed $20,000 on a recourse auto loan at the time they defaulted. The car dealer repossessed the car and sold it for $15,000. Because it’s a recourse loan, the car dealer can secure a judgment for the remaining $5,000. It can then use that judgment to garnish the borrower’s wages or seize other assets to collect the deficiency amount. It’s important to know if you still owe after your car is repossessed.
Understanding the role of interest rates can also pay off when you borrow money. A recourse loan may have a lower interest rate because there is less risk for the lender. A lower rate can reduce your monthly payment and lower the overall cost of the loan.
Do Lenders Always Pursue Deficiency Amounts?
Lenders know it isn’t easy to collect a borrower’s assets. They will need to go to court and get a judgment to get the assets to satisfy the outstanding loan balance. This process takes time and money.
So lenders don’t always seize personal assets, even if they legally can. They may look for other options. Sometimes they agree to a short sale on a foreclosed home, which usually includes an agreement not to pursue a deficiency balance. They may also use a deed in lieu of foreclosure to avoid a foreclosure sale, which often includes the same agreement. Lenders may even be willing to consider a new payment plan that’s more manageable for the borrower.
Sometimes if a foreclosed home sells for less than the mortgage balance, the bank chooses not to try to collect the deficiency amount. Instead, they forgive or cancel the debt. While debt forgiveness might sound like a windfall, it may come with a tax liability. Forgiven debt is considered taxable income by the IRS. This is referred to as discharge of indebtedness income or cancelation of debt (COD) income.
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With non-recourse loans, lenders can only take back the collateral that was named in the loan agreement. If the borrower defaults, the lender can’t try to get a court order to collect other personal assets, even if the collateral’s value is less than the outstanding loan balance. They assume that risk going in.
Lenders want to reduce their risk of not recovering on a defaulted loan. One way they do this is by offering non-recourse loans to people with good credit and steady income. They are more likely to pass tougher qualification requirements. Also, most reverse mortgages are non-recourse loans.
While banks don’t usually offer loans that are non-recourse, residential real estate loans (mortgages) are treated as non-recourse in twelve states: Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah, and Washington. Even in these states, there may be exceptions outlined in state law.
Non-Recourse Loans Are Less Risky for Borrowers
Borrowers generally prefer non-recourse loans because they only risk losing the collateral in the case of default. For example, assume a homeowner with a non-recourse mortgage defaults on a $300,000 loan and the house sells for $250,000 in a foreclosure sale. This is an example of a mortgage that is “underwater.” Because it’s non-recourse, the bank can’t attempt to recover the $50,000 deficiency amount from the homeowner’s assets. Though they will get the proceeds from the foreclosure sale.
Because mortgage lenders view this type of loan as riskier, it often has a higher interest rate. Also, unlike recourse loans, if the lender forgives or cancels the remaining debt, it isn't taxable. But defaulting on the loan could have a significant impact on a credit score.
Which Type of Loan Should You Choose?
If you have a choice when it comes to the type of debt, you should weigh the advantages and disadvantages of each to determine which is best for your situation.
On the upside, recourse loans often come with lower interest rates, and they are often easier to qualify for. That’s good if your credit history has some blemishes or your income hasn’t been stable. On the downside, recourse loans put your assets at risk. If you’re confident you’ll be able to repay the loan, you may be able to save a lot of money by opting for a recourse loan with a low interest rate. The cost savings may outweigh the risk of losing assets in the event of default.
With non-recourse loans, the upside is that your assets aren’t at risk if you default. And if a lender cancels or forgives any remaining debt, it’s not considered taxable income. On the downside, interest rates are often higher and your credit history and income are more important to qualify for the loan.
In many situations, you don’t get to choose whether your loan is recourse or non-recourse. This is the case with most car and home loans. But it can’t hurt to ask questions now that you know the difference.
Recourse and non-recourse are the two basic types of mortgage loans. Both recourse and non-recourse loans may be secured by collateral, such as a home in the case of a home loan. If a borrower defaults on a recourse loan and there’s a deficiency balance after the sale of the collateral, the bank can go after the borrower’s personal assets. If it’s a non-recourse loan, the bank can’t go after personal assets.
There are also other factors you should consider when getting a loan. It may be easier to qualify for a recourse loan and the interest rate may be lower, which could save you a lot of money. But you’ll have to decide if it’s worth the risk of putting personal assets like your income on the line. Understanding the difference between recourse and non-recourse debt can save you money and help protect your hard-earned assets.