What is nonrecourse debt?
If you default, the lender can seize the collateral — and nothing more
With most debts, if you find yourself unable to repay, not only does the lender have the right to seize your collateral, such as your house or car, but they can also pursue your other assets to make up for any remaining debt. However, there is a different type of debt known as nonrecourse debt, which provides you with a significant level of protection in case of default.
When you have a nonrecourse debt, your assets, with the exception of the collateral, are shielded from being targeted if you fail to fulfill the loan obligations. This type of loan is riskier for lenders, so there are usually stricter credit score and loan-to-value ratio requirements.
Key insights
- If you default on a nonrecourse loan and the collateral doesn’t cover the amount owed, the lender can’t pursue further action to collect the money.
- Nonrecourse loans present higher risk to a lender, so they have stricter eligibility requirements.
- State laws may determine whether a loan is a recourse or nonrecourse debt.
Nonrecourse debt vs. recourse debt
The key difference between recourse and nonrecourse debt is what the lender is allowed to take if you default on the debt.
- For a nonrecourse debt, a lender can only seize the collateral to compensate for the unpaid loan.
- A recourse debt allows the lender to pursue other assets besides the collateral if the loan balance isn’t covered.
Home loans are nonrecourse in Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah and Washington.
Nonrecourse debt
The risk to you, the borrower, is smaller with a nonrecourse debt because the collateral is the only asset at stake.
“If you get into hot water, you're only liable for the collateral and the debt won't follow you,” explained Jake Hill, CEO of DebtHammer, a debt relief company in Austin, Texas.
The risk to the lender is greater with a nonrecourse loan. Many lenders don’t offer nonrecourse loans. Those that do tend to require excellent credit scores, and they typically charge higher interest rates.
Keep in mind that just because it is less risky to you doesn’t mean there aren’t negative consequences for defaulting on a nonrecourse debt.
“If you default on a nonrecourse loan, your collateral is forfeited,” Hill said. “So if you offered up your home as collateral, the lender will own it.”
Recourse debt
When you take on a recourse debt, you are assuming full liability for the debt, including any deficiency left over after the collateral is seized. This means the lender may have the right to, for example, levy accounts or garnish wages to recover loan funds. A recourse loan is therefore less risky for the lender than a nonrecourse loan.
The benefit of a recourse loan is that the interest rates and credit requirements are typically lower since you keep the responsibility of repaying the full debt.
Examples of recourse debt
Recourse loans are more widely available than nonrecourse loans. If you apply for a car loan or mortgage, it is likely a recourse debt unless you live in a state that requires nonrecourse loans.
Auto loans
Home loans (usually)
In a nonrecourse mortgage, if you default, the lender can only seize the property that secures the loan, even if its value has fallen below the outstanding loan balance. In most states, however, the lender can go after any balance that remains after the sale of the home. It does this by, for instance, pursuing a deficiency judgment from a court, which gives the lender the legal right to collect the remaining debt.
What happens when you don’t pay back a loan?
You should always attempt to pay any debts you owe. If you default on a loan, the implications are different for recourse and nonrecourse debts.
| Nonrecourse | Recourse | |
|---|---|---|
| Lender seizes collateral | ||
| Credit negatively affected | ||
| Lender can take legal action to collect deficiency | ||
| Forgiven deficiency is possibly taxable |
Daniel, a borrower from Louisiana, defaulted on a recourse loan and faced wage garnishments, he told ConsumerAffairs. He eventually reached out to a debt relief company for help.
“I was worried about how I was going to make ends meet, and I was scared about what would happen if I didn't pay my debt back,” he said. “I knew I needed to do something. … Thankfully, it did work, and I was able to get my debt forgiven. It was such a relief to be free of that weight.”
» MORE: What is preforeclosure?
FAQ
Are there laws to protect borrowers?
The Truth In Lending Act is one of the main laws that protect those who use consumer credit, like mortgage loans and personal loans. It requires lenders to provide specific information that makes it easier to comparison shop:
- Annual percentage rate (APR)
- Total finance charges
- Amount financed
- The total of all payments
- Late fees
- Interest rate increases
- Service charges and fees
Another law that protects consumers is the Fair Debt Collection Practices Act, which prohibits debt collection companies from using unfair, abusive or deceptive methods to collect debt, like contacting you before 8 a.m. or after 9 p.m.
Are there tax implications if a lender writes off a portion of my debt?
If you have a recourse loan and any of the debt is forgiven, that amount may be considered taxable income. It’s a good idea to speak with a tax professional and describe your specific situation so you know if the canceled debt adds to your tax liability.
What can you do if you can’t pay off recourse debt?
If you are facing trouble paying a debt, it’s best to act quickly. In some cases, you can come to an agreement with the creditor. Some resolutions include:
- Forbearance: A creditor may allow a pause or reduction in payments for a certain amount of time to allow you time to resolve financial problems.
- Loan restructuring: A lender may agree to change the terms of your loan, such as by lowering the interest rate or extending the term.
If you’re uncomfortable doing these negotiations, you could contact a credit counseling organization or a debt relief company.
Bottom line
When you’re borrowing money, it’s important to know if you are taking on recourse or nonrecourse debt — even if you can’t imagine ever failing to repay the loan. Nonrecourse debt is more favorable to the borrower because there’s less financial exposure if you default. However, nonrecourse loans are harder to qualify for and typically come with higher interest rates.
Check your loan offer to find out if you are signing for a recourse or nonrecourse loan, and ask a lender representative if it’s unclear.
Article sources
- IRS, “ Recourse vs. Nonrecourse debt .” Accessed June 17, 2022.
- Office of the Comptroller of the Treasury, “ Truth in Lending .” Accessed June 17, 2022.
- Consumer Financial Protection Bureau, “ Are there laws that limit what debt collectors can say or do? ” Accessed June 17, 2022.
