Recourse Loan: What it is, How it Works, Example

What Is a Recourse Loan?

The term recourse loan refers to a type of loan that can help a lender recoup its investment if a borrower fails to pay and the value of the underlying asset is not enough to cover it. A recourse loan is a form of secured financing. It lets the lender go after the debtor's other assets that were not used as loan collateral or to take legal action in case of default in order to pay off the full debt.

Understanding Recourse Loans

Borrowers have several options available to them when they need financing. One type of loan is a secured facility. This kind of debt requires collateral—an asset that a borrower puts down as security. The lender is able to seize this asset and sell it to satisfy the debt in case the borrower defaults.

A recourse loan is a type of secured debt commonly found in some real estate and automobile loans. They give lenders a higher degree of power because they have fewer limits on what assets lenders can go after for loan repayment. In fact, a recourse loan allows the lender to seize the collateral as well as any other assets of the debtor. The lender may also take legal action against the borrower as well.

The lender can seize 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. This can include garnishing their wages. Garnishment is a legal procedure in which a lender obtains a court order requiring the person's employer to withhold a portion of their earnings in order to pay the debt. These earnings can include wages, commissions, bonuses, and even income from a pension or retirement program.

The contract and terms of a recourse loan generally outline the types of assets that a lender can go after if a debtor fails to live up to their financial obligations. For instance, a full recourse loan allows the lender to go after any and all assets. In limited recourse loans, the lender can only pursue assets that are named specifically in the contract.

Types of Recourse Loans

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 may 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.

Recourse Loan vs. Non-Recourse Loan

Non-recourse loans are also secured forms of financing but they are inherently different from recourse loans. If a borrower defaults, the lender is only allowed to seize the collateral used to secure the loan and nothing else. This means any balance that remains after the security is sold must be written off. Many traditional mortgages are non-recourse loans, using only the home itself as collateral. So, if the homeowner defaults, the lender may seize the home but not any other assets belonging to the borrower.

Advantages and Disadvantages of Recourse Loans

Lenders that offer hard money loans may approve borrowers that other financial 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. The lender could go after the debtor's 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. But recourse loans such as hard money loans are often more expensive for the borrower than traditional financing provided by banks at the going rate. This is why lenders typically prefer issuing recourse loans, while borrowers prefer non-recourse loans.

Example of a Recourse Loan

Here's a hypothetical example of a recourse loan. Suppose 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 go after the borrower's other assets in order to make up the outstanding $100,000 and pay off the loan to close it.