What is a Recourse Loan?
A recourse loan is a type of loan that can help a lender recoup its investment if a borrower fails to pay the liability and the value of the underlying asset is not enough to cover it. A recourse loan lets the lender go after other assets of that debtor that were not used as loan collateral.
How a Recourse Loan Works
Recourse loans give lenders a higher degree of power because they have fewer limits on what assets lenders can go after for loan repayment. For example, suppose that a homeowner takes out a recourse loan for $500,000 to purchase a home and then goes into foreclosure after the local housing market declines. If the value of the home is now down to $400,000 and it was purchased with a recourse loan, the lending institution can target the borrower's other assets in order to make up for the outstanding $100,000.
By contrast, many traditional mortgages are non-recourse loans, using only the home itself as collateral. If the homeowner defaults, the lender may seize the home but not any other assets belonging to the borrower.
A recourse loan may be easier for borrowers to obtain, but it also puts more of their assets at risk in the event of a default.
The terms of a recourse loan allow the lender to pursue compensation by, for example, taking money from the borrower’s savings, checking, or other financial accounts. They also grant the lender the right to tap into certain income sources of the borrower. That can include garnishing their wages. Garnishment is a legal procedure in which a lender—or other party who is owed money—obtains a court order requiring the person's employer to withhold a portion of their earnings in order to pay the debt. Those earnings can include wages, commissions, bonuses, and even income from a pension or retirement program.
Certain types of financing can be classified as recourse loans. For example, hard money loans for real estate acquisitions would be considered recourse loans. The terms of a hard money loan give lenders the opportunity to take possession of the property in the event of default and then resell it themselves. Lenders might even agree to provide this financing with the hope of taking ownership of the property because they believe they can resell it for a greater gain.
Pros and Cons of a Recourse Loan
A recourse loan, such as a hard money loan, may be more expensive for the borrower than traditional financing provided by banks at the going rate.
However, lenders that offer hard money loans may approve borrowers that other institutions would reject. For that reason, borrowers with a limited or poor credit history might turn to this type of loan.
The leniency regarding approvals comes with a caveat for borrowers, of course: The lender could go after their other assets in the event of a default. Note, though, that there can be limits on the types of assets the lender may attach to the loan—a good reason to read any contract carefully.
From the lender's point of view, a recourse loan reduces the perceived risk associated with less creditworthy borrowers. The potential for the lender to seize property beyond the initial collateral can quell some concerns that the borrower will not make good on the debt.