When shopping for a mortgage, there are many factors to consider, including your comfort level with the lender, if the lender services the loan, the amount you can afford and the interest rate.
But there’s also something else you should think about: Is it a recourse or nonrecourse loan? Let’s take a look at how recourse and nonrecourse loans compare below.
What Is A Nonrecourse Loan?
A nonrecourse loan is a type of collateral loan, or a secured loan, where your property secures the debt and can be seized if you default on your payments. A nonrecourse mortgage loan favors the borrower because it assures the borrower loses only their collateral and will never owe more on their loan than the asset is worth.
This means that if you fail to pay your mortgage and the lender forecloses on your home, that’s all they can legally do. If the lender sells the foreclosed property and doesn’t make their money back on the defaulted amount, it’s their loss. There isn’t any further legal action lenders can take to recoup lost funds from your personal assets.
What Is Nonrecourse Debt?
Nonrecourse debt is a type of debt that’s secured by collateral. This collateral is the only asset a lender can take if you default on the debt. The lender can only use that collateral to cover the amount of debt owed. If the collateral doesn’t cover the amount of debt, the lender cannot seize any other property or money from you.
Nonrecourse doesn’t get you off the hook for paying back your debts. As a borrower, you’re responsible for paying back your loan. If you don’t, you’ll still lose that asset, the default will be on your record and your credit will be negatively affected.
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What Is A Recourse Loan?
A recourse loan is also a secured loan, but it favors the lender because it allows them to pursue legal action even after the collateral (for example, your home) has been seized. With a nonrecourse loan, the lender can lose money after selling your foreclosed house and will need to walk away without recouping the difference. With a recourse loan, a lender can potentially garnish your wages or pursue legal action to levy your bank account to make up for the amount they lost after calculating the amount recouped from selling your home.
Recourse Loan Example
A common example of a recourse loan is your car loan. Auto loans are typically recourse loans because car values are notorious for dropping as soon as you drive away from the dealership. Let’s say you get a car loan for $20,000 to purchase a car. As you drive the car, the vehicle’s value drops over time. However, your loan amount remains the same.
Let’s say that after a year of owning the car, you stopped making payments, but you still owe $16,400 on the loan. The lender could seize the car, but by now the car is only worth $14,000. Because the loan is a recourse loan, the lender could still try to reclaim the additional $2,400 to cover the remaining debt.
Can Lenders Forgive Recourse Debt?
In some situations, rather than pursuing legal action, a lender may forgive a portion of the debt that isn’t covered by the collateral. For example, a lender may agree to a short sale or deed in lieu of foreclosure. This can not only help lenders avoid the long and expensive process of foreclosure. It also helps borrowers who have fallen on hard times settle their debts without having to worry about further legal action.
In a short sale, you’d put the home up for sale and the lender would choose which offer to accept, agree to take that sale price as the loan payoff amount and absorb the rest of what’s owed.
With a deed in lieu of foreclosure, you would sign your home over to the lender instead of the lender foreclosing on the home. With this voluntary act, the lender agrees to forgive any remaining balance after the home is sold.
Though neither of these situations is ideal, they benefit both parties by resolving the debt and avoiding further legal disputes.
How Do I Find Out Whether I Have A Recourse Or Nonrecourse Loan?
There are a variety of situations that can determine your loan’s terms. To know where you stand, look over your mortgage note. All the terms of your mortgage are included in that document. If you’re facing foreclosure, contact an attorney or legal service for help.
Look Up Your State Law
Whether a loan is a nonrecourse loan generally depends on the laws of the state where the loan originates. There are 12 states that, by law, only allow nonrecourse loans. These are known as “nonrecourse states,” and they include Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah and Washington.
You can research online for your state and see where the state laws fall on whether your loan is recourse or nonrecourse and how that can change with impending foreclosure. You may also be able to review your mortgage agreement, ask your lender or consult a real estate attorney.
Check What Type Of Loan You Have
Some types of home loans are nonrecourse by definition. For example, most reverse mortgages are nonrecourse loans, because financial products targeted at seniors are often afforded greater consumer protection.
Negotiate With Your Lender
A borrower with near-perfect credit might be able to negotiate with their lender to include a nonrecourse clause at no additional cost while shopping for a mortgage. All others would have to be willing to pay a higher interest rate for a nonrecourse loan.
Recourse Vs. Nonrecourse Loans: Key Differences
The main difference between recourse and nonrecourse loans is which assets of yours a lender can pursue if you (the borrower) can’t repay the loan.
But there are other factors that distinguish recourse loans from nonrecourse loans. It’s important to consider these when choosing what loan is right for you. Let’s take a look at some of the key differences:
- Nonrecourse loans are favored by borrowers, while recourse loans are favored by lenders.
- Nonrecourse loans are riskier for the lender. Recourse loans are riskier for the borrower.
- Since recourse loans are less risky for lenders, they’re usually offered at lower interest rates. Nonrecourse loans typically have higher interest rates.
- Nonrecourse loans are typically offered more to borrowers who have great credit and are in good financial standing.
Depending on the situation there are several factors that might make a recourse or nonrecourse loan preferable. Let’s take a look at how interest rates and tax implications can impact these advantages and disadvantages.
Interest Rates
Interest rates are generally higher with a nonrecourse loan than with a recourse loan. The reasoning for this is that there’s a higher risk to the lender on a nonrecourse because they can’t seize other assets you have if your home doesn’t sell for at least the outstanding loan balance. With this higher risk comes a higher interest rate.
It’s also important to note that a recourse option might be the only way to get a loan if you have a lower credit score or a higher debt-to-income ratio (DTI).
Tax Implications
There are no tax implications if you have a nonrecourse loan. But with recourse loans, if your debt is canceled by the lender following a foreclosure (meaning you don’t have to pay off a certain portion of the debt), you may be required to claim the portion of the debt that has been forgiven as income on your taxes. That’s because when you borrowed the money, you were required to pay it back, so it wasn’t seen as income. Now that you aren’t required to pay it back, it could be seen as income.
Not all debt cancellations are taxable. According to IRS tax guidelines, debt cancellation due to bankruptcy, insolvency and on certain farm debts may be exceptions to the rule.
Which Loan Option Is Best For You?
Each loan has its benefits and drawbacks, and just like any important decision, it’s best to compare the pros and cons to determine the best loan option for you.
When To Consider A Nonrecourse Loan
The best reason for choosing a nonrecourse loan is that it favors you, the borrower, and helps protect your other assets should you default on your loan. While you should never get a loan if you think you’ll default, a nonrecourse loan is riskier to lenders than a recourse loan.
If you have excellent credit and strong personal finances, a recourse loan provides an extra level of security should you ever fall on hard times. That said, you’re likely to pay a bit more in interest in exchange for protecting your assets.
When To Consider A Recourse Loan
Depending on where you live you might not have a choice between a recourse versus a nonrecourse loan. Unless your property is located in a nonrecourse state, a recourse loan may be your only option.
If you do have a choice, you should choose a recourse loan if you have stable income and the risk of defaulting on your loan is very low. It’s also a good option if you’re looking for a lower interest rate than what a nonrecourse loan may offer.
The Bottom Line
With a nonrecourse loan, you’ll never owe more than what your collateral is worth. Nonrecourse loans offer extra protection for the borrower in exchange for a higher interest rate. Whether your mortgage is a recourse or nonrecourse loan may affect your interest rate and could impact how your lender proceeds in the event of a foreclosure.
Though nonrecourse loans have benefits, they won’t always be available to borrowers. Your location and the type of loan available may limit your ability to choose a nonrecourse over a recourse loan. If you’ve got questions about your loan type, you can always check your mortgage note or talk to your mortgage lender for more information.
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