A loan is usually backed or “secured” by collateral. Collateral is property that the lender can access if the borrower goes into debt and fails to pay back their borrowed money. With recourse debt, the lender is allowed to “look beyond” the pledged collateral and may be able to hold the debtor accountable for any unpaid balance, allowing them to recover the full value of the amount that they loaned out.
In contrast, with non-recourse debt, the lender can only access the collateral to make up for defaulted payments on the loan, sometimes leading to the lender experiencing losses.
Each state upholds different laws regarding recourse debt vs. non-recourse debt. Some states are “non-recourse states” and don’t allow the lender to go beyond the collateral for debt payment. Recourse and non-recourse debts can have different tax consequences for both parties.
What Are Examples of Recourse Debts?
Most car loans and auto financing arrangements are recourse debts. If the borrower defaults, the lender can repossess the car and sell it, usually at auction. The amount the car sells for may be less than the amount owed on the loan because vehicles depreciate significantly in their first couple of years. If there’s a balance left on the loan, the lender can pursue the borrower’s other assets to recover the remainder of the debt.
Most mortgage loans are recourse loans. A smaller group of states limits what a lender can collect after a foreclosure. These are usually called non-recourse states. The list most often includes Alaska, Arizona, California, Minnesota, North Carolina, North Dakota, Oregon, and Washington.
The label is a little misleading. No state bans recourse home loans. What these states do is limit or block the lender’s right to sue for the balance left over after a foreclosure sale. That leftover balance is called a deficiency.
The protection also comes with conditions. It can depend on how the lender foreclosed, whether the loan was used to buy the home, and what type of property it is. Washington, for example, blocks a deficiency after an out-of-court foreclosure but allows one after a court foreclosure.
Connecticut, Idaho, Texas, and Utah are sometimes added to non-recourse lists. That is not correct. All four allow deficiency judgments by law, though each caps the amount using the home’s fair market value. These rules change, so check your own state’s current law.
Lenders don’t always pursue assets beyond the collateral in cases of default, especially by individuals. Seizing assets is a time-consuming and expensive process. Lenders may choose to write off a loss rather than continue to pursue it.
Recourse loans have lower interest rates than non-recourse loans. If a borrower fails to live up to their obligation and defaults on the payment schedule, the lender will seize and sell the collateral specified in the loan. If that is not sufficient to repay the loan amount, the lender can seize the borrower’s other assets or sue to garnish the borrower’s wages.
From a lender’s point of view, recourse loans reduce the potential risk associated with less creditworthy borrowers.
Because lenders can reduce the risk associated with recourse loans, they can charge lower interest rates. Lower interest rates make recourse debt more attractive to borrowers. Recourse loans may be the only loan available to a borrower with a poor credit history.
Recourse loans are most common when banks and other financial institutions tighten up their lending practices. When the economy is rocky, credit markets get more conservative, and lenders raise their standards.
What Are Examples of Non-Recourse Debts?
Many banks avoid making non-recourse loans. These loans leave the bank open to a loss if the borrower defaults and the collateral is not worth enough. If a balance is left after the collateral is sold, the lender has to absorb it. The lender has no claim on the borrower’s other money, property, or income.
Borrowers with strong credit histories may be able to get a non-recourse loan, but the terms are harder. Expect a higher interest rate and a larger down payment.
Failure to pay off a non-recourse debt has penalties, including loss of the collateral and damage to the borrower’s credit score.
To What Types of Loans Do These Laws Apply?
The concept of recourse vs. non-recourse lending is most commonly used in a real estate mortgage loan. In real estate mortgage loans, the collateral would be the home that the mortgage applies to. In the event of a foreclosure, the results could be very different depending on whether the home sits in a non-recourse state or not.
What is a Deficiency Judgment?
In a recourse state, the lender might be able to foreclose on the home and then ask the court for a deficiency judgment. This is an order making the borrower pay the balance left after the sale. If they no longer have any money at that point, the lender might even be allowed to reach the borrower’s other assets to make up for the payments. For instance, they might have the court initiate a lien on the person’s car and then seize it for the payments.
In a non-recourse state, the lender can usually only foreclose on the home and recover what the sale brings in. If that does not cover the debt, the lender takes the loss. Non-recourse states have “anti-deficiency” laws that stop the lender from reaching beyond the collateral.
Non-recourse laws generally protect the borrower from excess or abuse if there is a default. These laws can be very complicated and generally require the assistance of an attorney when dealing with them.
How Does Recourse or Non-Recourse Vary from State to State?
Whether a mortgage loan is recourse or nonrecourse varies from state to state, depending on the particular state’s laws. Many states allow banks to obtain a deficiency judgment, but restrictions apply. The deficiency is often limited by the property’s fair market value.
For example, if a total debt is $100,000 and the bank bids $50,000 at the foreclosure sale and purchases the property using a credit bid, the deficiency is $50,000. The bank could get a deficiency judgment for $50,000 and collect that amount from the borrower. However, if the property’s fair market value is $75,000, the lender could only get a deficiency judgment of $25,000.
Because the bank is typically the only bidder at the foreclosure sale, a fair market value limitation prevents the bank from making extremely low bids to collect large deficiency judgments.
Some states, including Arizona, California, and Oregon, block deficiency judgments in certain situations. Common examples are a foreclosure handled outside of court, or a loan that was used to buy the home. In other states, the process for obtaining a deficiency judgment is so burdensome or time-consuming that banks typically opt to forgo pursuing one.
Should I Hire a Lawyer for Help Understanding Recourse Debt vs. Non-Recourse Debt?
Recourse and non-recourse laws can often affect how debts and transactions work out in the long run. Such laws often change depending on market conditions, especially real estate values. You may need to hire a mortgage lawyer for assistance and representation if you have any legal issues involving property debt. Your attorney can provide you with the legal advice and guidance needed to succeed on your claim and help you defend your property interests.
Consider using LegalMatch’s services today if you have questions regarding recourse and non-recourse laws. These laws are hard to sort out on your own, and a lawyer can help. LegalMatch can pair you with the right mortgage attorney for assistance and representation regarding your legal issue. There is no fee to schedule a consultation, and our services are entirely confidential. Use LegalMatch to solve your legal issues today.
