The essential difference between a recourse and non-recourse loan has to do with which assets a lender can go after if a borrower fails to repay a loan.
In both types of loans, the lender is allowed to take possession of any assets that were used as collateral to secure the loan. In most cases, the collateral is the asset that was purchased by the loan. For example, in both recourse and non-recourse mortgages, the lender would be able to seize and sell the house to pay off the loan if the borrower defaults.
The distinction comes into play if money is still owed on the debt after the collateral is sold. In a recourse mortgage, the lender can go after the borrower’s other assets or sue to have his or her wages garnished – anything to be made whole, basically. In a non-recourse mortgage, however, the lender is out of luck. If the asset does not sell for at least what the borrower owes, the lender must absorb the difference and walk away; he has no claim on the lender’s other funds or funding sources.
Not surprisingly, as a matter of principle, borrowers almost always favor non-recourse loans, while lenders almost always favor recourse loans. While potential borrowers might find it attractive to hold out for non-recourse loans, it is important to remember that they come with higher interest rates and are reserved for individuals and businesses with the best credit. Additionally, failure to pay off a non-recourse debt may leave a borrower’s other assets untouched, but the default is still on record, with all that implies for the borrower’s credit score, the impact of which is not positive one.
A recourse loan is a type of loan that allows a lender to seek financial damages if the borrower fails to pay the liability, and if the value of the underlying asset is not enough to cover it. A recourse loan allows the lender to go after the debtor’s assets that were not used as loan collateral in case of default.
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 when the local housing market declines. If the value of the home is now only $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.
Full Recourse Debt
A full recourse debt is a guarantee that no matter what happens, the borrower will repay the debt. Typically with a full recourse loan no occurrence, such as loss of job or sickness, can get the borrower out of the debt obligation. In this situation, if there is no collateral for the loan, the lender can go after the borrowers personal assets to collect if the loan is defaulted.
In contrast, a limited recourse loan would only allow the lender to take assets that are listed as collateral in the signed loan agreement. Also, a non-recourse loan would have no collateral and the lender would only be able to take the asset that is being financed, such as a home in a non-recourse mortgage.
Limited Recourse Debt
A limited recourse debt is a debt in which the creditor has limited claims on the loan in the event of default. Limited recourse debt sits in between secured bonds and unsecured bonds in terms of the backing behind the loan. Often a limited recourse debt contract is structured so that the debt transitions to unsecured, or non-recourse, debt pending the completion of a specific event. That event may be the completion of a project or the establishment of a specific revenue stream for which the debt was issued.
For example, terms for limited recourse debt for a large project such as a power plant could mean that a creditor is guaranteed to receive 25% of the principal in the event of a default up until completion of the power plant.
Limited recourse debt will typically pay a lower rate than standard issue unsecured bonds because of its relative safety. Claims on limited recourse debt sit above both stockholders and unsecured bondholders in terms of payout hierarchy.
Non-recourse finance is a loan where the lender is only entitled to repayment from the profits of the project the loan is funding, not from other assets of the borrower.
These types of projects are characterized by high capital expenditures, long loan periods and uncertain revenue streams. Analyzing non-recourse financing requires a sound knowledge of the underlying technical domain as well as financial modeling skills.
Considered a fairly high-risk undertaking on the part of lenders, non-recourse financing does not include access to any of the borrowers’ assets beyond the agreed upon collateral, even if they default on the loans. Payments on such loans can only be made as the funded projects generate revenue. Due to the uncertainty, loan periods are generally long to give ample time for projects to produce returns. Additionally, interest rates are generally higher on non-recourse loans, corresponding to the elevated risk involved. If projects produce no revenue during the loan periods, lenders receive no payments on the debt and cannot go after the borrowers for remaining balances after collateral is seized.
Examples of Recourse versus Non-Recourse Loans
If two people are looking to purchase large assets, such as a homes, and one receives a recourse loan and the other a non-recourse loan, the actions the financial institution can take against each borrower are different. In both cases, the homes may be used as collateral, meaning they can be seized should either borrower default. To recoup costs when the borrowers default, the financial institutions can attempt to sell the homes and use the sale price to pay down the associated debt. If the properties sell for less than the amount owed, the financial institution can pursue only the debtor with the recourse loan. The debtor with the non-recourse loan cannot be pursued for any additional payment beyond the seizure of the asset.
A non-recourse sale is a transaction in which a creditor turns a bad debt over to a third party in exchange for a percentage of the total debt amount, and in which the third party is without means of redress or compensation if the debt remains uncollectible. In a recourse sale, the third party could try to sell back any uncollectible debts.
After purchasing bad debts for pennies on the dollar, debt collectors can keep as profit whatever portion of the debts they are able to collect. The original owner of the bad debt (e.g., a credit card company) gets a liability off its books and saves the time and expense of making further attempts to collect a stubborn debt. A non-recourse sale entails more risk for the purchaser of the bad debts, but usually means the seller is finished dealing with them once and for all.
A non-recourse debt is a type of loan secured by collateral, which is usually property. If the borrower defaults, the issuer can seize the collateral but cannot seek out the borrower for any further compensation, even if the collateral does not cover the full value of the defaulted amount. This is one instance where the borrower does not have personal liability for the loan.
With non-recourse debt, the creditor’s only protection against borrower default is the ability to seize the collateral and liquidate it to cover the debt owed. Because in many cases the resale value of the collateral can dip below the loan balance over the course of the loan, non-recourse debt is riskier to the lender than recourse debt, which allows the lender to come after the borrower for any balance that remains after liquidating the collateral. For this reason, lenders charge higher interest rates on non-recourse debt to compensate for the elevated risk.
Recourse vs. Non-Recourse Debt
Recourse debt gives the creditor full autonomy to pursue the borrower for the total debt owed in the event of default. After liquidating the collateral, any balance that remains is known as a deficiency balance. The lender may attempt to collect this balance by several means, including filing a lawsuit and obtaining a deficiency judgment in court. If the debt is non-recourse, the lender may liquidate the collateral but may not attempt to collect the deficiency balance.
For example, consider an auto lender who loans a customer $30,000 to purchase a new vehicle. New cars are notorious for declining precipitously in value the minute they are driven off the lot. When the borrower stops making car payments six months into the loan, the vehicle is only worth $22,000, yet the borrower still owes $28,000. The lender repossesses the car and liquidates it for its full market value, leaving a deficiency balance of $6,000. Most car loans are recourse loans, meaning the lender can pursue the borrower for the $6,000 deficiency balance. In the event it is a non-recourse loan, however, the lender forfeits this sum.
Non-Recourse Debt Underwriting
Non-recourse debt is characterized by high capital expenditures, long loan periods and uncertain revenue streams. To preempt deficiency balances, loan-to-value (LTV) ratios are usually limited to 60% in non-recourse loans. Lenders impose higher credit standards on borrowers to minimize the chance of default. Non-recourse loans, on account of their greater risk, carry higher interest rates than recourse loans.
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