Recourse vs. nonrecourse loans

Recourse loans

When you take out a loan, the lender has the right to make collection efforts against you if you don’t pay back the loan as agreed. Recourse loans allow the lender to take full action against a borrower if they default.

Leslie Tayne, founder and head attorney at Tayne Law Group, explains, “Recourse loans allow the lender to seize the borrower's collateral, as well as other assets, if the borrower defaults. The benefit of a recourse loan is that it will likely come with a lower interest rate, and they are quite common, especially among auto loans and mortgages.”

With recourse loans, lenders can seize collateral, but if the collateral doesn’t pay off the balance, the lender can sue for the remainder. This can result in garnished wages or levied accounts. Car loans are common types of recourse loans because the lender can repossess the vehicle if you default on the loan.

For example, if you owe $25,000 on a car with a recourse loan and don’t make the payments, the lender can take possession of the car and sell it to recoup its losses. If the car only sells for $17,000, you’ll still owe the lender $8,000 and it can attempt to collect the difference from you.

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Nonrecourse loans

If you have a nonrecourse loan, the most the lender can do is repossess the loan’s collateral and sell it for as much as possible to cover the balance owed on the debt. If the sale doesn’t cover the amount owed, the lender must take a loss. This can make nonrecourse loans more difficult to qualify for.

“Nonrecourse loans can be difficult to find, and are usually limited to borrowers with strong credit, significant assets,or highly profitable projects. This is because lenders take on more risk with nonrecourse loans, as they can only seize previously agreed-upon collateral if the borrower defaults,” Tayne says. “Note that nonrecourse loans typically come with a higher interest rate than recourse loans; again, this is because the lender's risk is higher.”

Even if a lender can’t sue you for the remaining balance on a nonrecourse loan, you can still face more negative consequences. Defaulting on a loan can result in a hit to your credit score and any late payments can show up on your credit report. These negative marks can make it difficult to qualify for financial products in the future.

Recourse vs. nonrecourse loans: Key differences

The main difference between a recourse loan and a nonrecourse loan is what happens if you default on a loan.

In both cases, the lender can seize the collateral of the loan, but with a recourse loan, it can also take legal action against you if the collateral doesn’t fully pay off the balance due. However, with a nonrecourse loan, the lender is limited to repossessing the collateral and cannot take further action if the loan is not paid in full after the asset is sold.

Lenders take more risk with a nonrecourse loan since they’re limited to the value of the asset if you default on the loan. However, recourse loans are riskier for the borrower, since the lender can sue for the full amount due in the event of a default.

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Tax implications of recourse vs. nonrecourse loans

With either type of loan, any amount of debt that the lender forgives or cancels is considered ordinary income to the borrower. For example, say you owe $10,000 on a car that is repossessed and sold for $7,000. If the lender forgives the remaining $3,000 balance, whether on a recourse or nonrecourse loan, the $3,000 would be treated as income for that year and taxed accordingly.

If you have a nonrecourse loan and your asset is seized by a lender due to defaulting on a loan, the Internal Revenue Service (IRS) considers this a sale of the asset to the lender. If the asset is sold for more than you paid, you may owe taxes on the gain in value. If the fair market value of the asset is less than you paid, you may be entitled to a tax deduction.

“If you part with the collateral stated in the contract of your nonrecourse loan, the IRS treats it like you sold it,” Tayne explains. “This would mean you may have to pay taxes on any profits gained, or you could qualify for a deduction if you lost money.”

Keep these tax implications in mind when you take out any type of loan because that extra income you must report may affect any tax refunds or payments you make the following year.

Choosing the right loan type

Nonrecourse loans are less risky for the borrower; therefore, when reasonable, it’s better to choose a nonrecourse loan. However, nonrecourse loans are more difficult to qualify for, as they involve greater risk for the lender.

"It's never a bad idea to limit your liability if you can, but sometimes it's not always easy to access nonrecourse debt if you aren't buying specific assets or don't have a lot of collateral,” says Chris Motola, special projects editor and financial analyst at National Business Capital. “In these cases, a nonrecourse loan may be your best option. Just be reasonably confident you can pay it back."

Nonrecourse loans often have higher interest rates or shorter terms than recourse loans to reflect the additional risk to lenders. 

When choosing a loan, select the one with the lowest interest rate and fees. You’ll also want to ensure you can comfortably meet the minimum payment. Whether or not the loan is recourse or nonrecourse only matters if you are unable to make the minimum payments. If you are sure you can pay off the loan, choose the loan terms that make the most sense for your finances.