Updated June 21, 2023
What is a Recourse Loan?
The term “recourse loan” refers to the loan type that makes the borrower fully liable for the entire loan balance. It is a secured form of loan where the borrower needs to provide some asset or income stream as collateral in the loan agreement. If the borrower defaults on the loan payment, the lender has the legal right to take possession of the collateral to recover the losses. Further, if the sale of the collateral fails to cover the losses, i.e., the collateral’s market value is less than the loan’s outstanding balance. The lender can seize the borrower’s other assets to recover the remaining losses. This is what makes a recourse loan different from other forms of debt financing instruments.
Key Takeaways
Some of the key takeaways of the article are:
- A recourse loan is a financing instrument in which the lender can seize the collateral and any other assets in the defaulter’s name to recover the debt money.
- Examples of other assets include other bank deposits, income sources, etc.
- A recourse loan is backed by collateral and the borrower’s liability. Hence, the lender has to assume significantly lower risk in this type of loan.
- Although there are many different recourse loans, the two most common types are hard money loans and auto loans. Not all mortgages are recourse loans, but the hard money loans in real estate purchases are recourse loans.
Examples of Recourse Loan
Let us now look at the following example to understand the concept of recourse loans.
Four years back, John got a stable job in a multinational company with an annual package of $75,000. Three months after joining the job, he purchased a house worth $300,000 in the countryside. However, when he checked his savings account, he realized that he had a savings of $60,000, which he decided to use as equity in this real estate purchase. So, he approached a bank for a housing loan of $240,000.
Based on his not-so-good credit history and current financial position, the bank manager suggested him an alternative debt instrument – a recourse loan. In the loan arrangement, he had to provide the financed property in the form of collateral, and repayment involved monthly principal payments of $2,500 for three years, followed by a bullet repayment of $150,000 at the end of the 4th year. The banker also took notice of his annual paycheck while offering the housing loan.
Unfortunately, today John defaulted on the bullet payment, and the lender immediately seized his house for foreclosure and subsequent recovery of the debt from the sale, resulting in proceeds of $75,000. So, the remaining $75,000 (= $150,000 – $75,000) plus the interest cost will be recovered through garnishment, wherein the outstanding loan balance will be directly deducted from his monthly paycheck until the entire loss amount is settled.
In this way, the recovery of losses occurs in a recourse loan when the borrower defaults.
Types of Recourse Loan
Various types of debt financing instruments can be classified as recourse loans. However, the two most common examples of recourse loans are as follows:
- Hard money loans: In the case of a real estate acquisition, a hard money loan is considered a recourse loan because its terms give the lender the right to take possession of the borrower’s property after default and then resell it for a more significant gain.
- Auto loans: Since the value of automobile cars depreciates over a period, which exposes the lenders to the risk of adequate recovery in the event of a default. Hence, most auto loans are recourse loans in nature.
Benefits of Recourse Loan
Some of the significant benefits of a recourse loan are as follows:
- Some assets adequately back it in the form of collateral. Besides, there is the total liability of the borrower, which means that the lender doesn’t need to bear too much risk.
- Borrowers get recourse loans as per their credit profile and financial position. People with good credit histories are offered favorable interest rates, while those with poor credit histories can get the loan on the back of their unlimited liability.
- With such flexibility in lending terms, these loans result in the maximum flow of money in an economy through more frequent and easy lending.
Disadvantages of Recourse Loan
Some of the significant disadvantages of a recourse loan are as follows:
- First, the borrowers who default on a recourse loan may lose much more than the collateral provided because the lender invariably goes after the borrower’s other assets and income stream to recover the outstanding loan balance.
- Further, the borrower who fails to repay a recourse loan loses not just the money, but such an event can be a very traumatic experience for them. It can get tricky for them to cope psychologically.
Conclusion
So, it can be seen that a recourse loan is a binding debt financing instrument that secures the lenders and makes their life much easier. But, on the other hand, it is not so favorable for the borrowers as they may be exposed to severe consequences in the event of a default. Hence, borrowers should consider all the aspects of the loans before signing up for any recourse loan.
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