What Is Recourse Financing?
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What Does Recourse Mean in Finance?
In the world of finance, a full recourse loan gives the lender the right to seize assets, besides the project collateral, to recoup all of their money if a borrower defaults. When a lender has recourse against the borrower, it protects them from financial loss when the value of the underlying asset turns out to be lower than the amount of debt at the time of seizure.
If a loan is recourse, the borrower will be fully liable for the debt and must repay it in full, one way or another. When the proceeds from the sale of collateral are insufficient to cover the remaining balance of the recourse loan, the lender may take and sell unpledged assets to make up the difference.
In most cases, a lender would need to obtain a deficiency judgment before taking more assets. Therefore, in most cases, the lender may take possession of assets only when the court approves the “recourse.”
In general, the terms of a recourse loan outline the types of assets a lender can seize if a borrower fails to satisfy their financial obligation. The usual unpledged assets a recourse loan lender may tap into are as follows:
- Financial accounts.
- Wages through garnishment.
- Pension or retirement program income.
If a loan is full recourse, the lender may pursue any or all the borrower’s assets until the debt is zeroed out. If a loan is non-recourse, the lender may seize only the assets specified in the loan agreement.
What Is the Difference Between Recourse and Non-Recourse Loans?
By definition, recourse financing is less risky to lenders, while non-recourse financing is more favorable to borrowers. A borrower will always prefer a non-recourse loan while a lender will always prefer a full-recourse loan. Even so, most borrowers end up using recourse loan providers because they do not have good enough credit to justify the lender’s risk in providing them a non-recourse loan.
For instance, a homebuyer with bad credit might not be able to get a good mortgage rate or qualify for a loan altogether because of the perception that they are financially incapable of handling this financial obligation properly.
In this case, the applicant might take out a hard money loan instead of dealing with a traditional lending institution with more demanding requirements. With hard money loans, the borrower’s creditworthiness isn’t unimportant, but it is less important than the value of the project collateral.
Lenders that offer non-recourse financing naturally take high risk. They do not have the luxury of seizing unpledged assets if the collateral they hold is not valuable enough when they have to resell it to recoup their capital.
As a result, non-recourse loan providers are very selective in approving applicants. These lenders heavily rely on credit-scoring models to meaningfully predict the likelihood that a borrower will not be able to repay on time until the loan matures.
That is why non-recourse financing may come with higher interests and may disqualify less creditworthy loan applicants.
BY THE NUMBERS: In the United States, home mortgages are non-recourse loans in 12 states, namely Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah, and Washington.
When Can a Non-Recourse Loan Become a Recourse Loan?
In commercial real estate, non-recourse loan contracts typically come with “bad boy” provisions or carve-outs. They specify the actions the borrower may commit in bad faith to blatantly or subtly trick the lender. Due to the malicious nature of “bad boy” acts, any of them can turn a non-recourse loan into recourse.
“Bad boy” acts can be outright fraudulent (like inaccurate financial statements) or strategically dubious (like voluntary bankruptcy filings). In other words, “bad boy” provisions serve as recourse for non-recourse loan lenders. Committing any violation could render the borrower personally liable for the loan. Subsequently, the lender could take legal action to seize more of the borrower’s assets if necessary.
These provisions can vary from contract to contract. They are negotiable and the language is written as narrow as possible to help protect the best interests of the borrower.
Vague terms do not guarantee that the borrower can simply walk away when a “bad boy” provision is violated. Acts of misrepresentation, even if not explicitly expressed in the contract, could be considered a violation. There have been precedents for court decisions favoring the lender in such cases.
Are Credit Cards Recourse Debt?
Most credit cards are structured as non-recourse loans and as a result, the interest rates on these lines of credit are much higher than other types of recourse financing.
Some credit cards are structured as recourse debt, specifically those issued to applicants with bad credit or no credit history.
The credit card provider may ask for collateral like a security deposit as a condition for application approval. In case of nonpayment, the lender may take the borrower to court and collect the money owed.
However, unpaid credit card debt may not follow the delinquent borrower around forever. Because of the statute of limitations, the lender only has a limited time to attempt to collect. If the lender takes longer than the allowed window to get the money owed by the delinquent borrower, the defendant may use the “time-barred” defense to convince the court to dismiss the lawsuit since the debt is no longer legally collectible.
The statute of limitations for credit card debt varies by state. Once the statute of limitations is up, a recourse credit card debt may become non-recourse.
BY THE NUMBERS: Seventeen U.S. states have a statute of limitation for credit card debt of three years, the shortest in the country, whereas Rhode Island has the longest, which is 10.
Source: InCharge Debt Solutions
- Recourse financing renders the borrower personally liable for the debt, empowering the lender to seize unpledged assets, if necessary, to collect the money owed and avoid financial loss.
- Non-recourse financing, on the other hand, frees the borrower from any personal obligation to cover the remainder of the debt in case of default, increasing the risk the lender has to take.
- Home mortgages, credit card bills, and auto loans are usually recourse, but they can be non-recourse.
- Under certain circumstances, recourse debt can become non-recourse, and vice versa.
- Pritchard, J. (2020.) What You Need to Know About Deficiency Judgments. The Balance. Retrieved from https://www.thebalance.com/deficiency-judgments-315547
- Arizona Department of Economic Security. (n.d.) Financial Account Types. Retrieved from https://dbmefaapolicy.azdes.gov/index.html#page/FAA4/Financial_Account_Types.html
- U.S. Department of Labor. (n.d.) Garnishment. Retrieved from https://www.dol.gov/general/topic/wages/garnishments
- Mint. (2020.) What is a Hard Money Loan & How Do They Work?. Retrieved from https://mint.intuit.com/blog/housing/what-is-hard-money-loan/
- Siddiqui, M. (2016.) Basis for “Bad Boys”. The Tax Adviser. Retrieved from https://www.thetaxadviser.com/issues/2016/nov/basis-for-bad-boys.html
- Latimer LeVay Fyock LLC. (n.d.) How a Non-Recourse Loan can become a Recourse Loan. Retrieved from https://www.llflegal.com/how-a-non-recourse-loan-can-become-a-recourse-loan
- Axelton, K. (2020.) How Secured Credit Card Deposits Work. Experian. Retrieved from https://www.experian.com/blogs/ask-experian/how-does-the-deposit-in-a-secured-card-work/
- Financial Outsourcing Solutions. (2020.) What Is Time-Barred Debt and How Does It Affect My Bank? Retrieved from https://fosaudit.com/what-is-time-barred-debt-and-how-does-it-affect-my-bank/