What is Recourse Debt?
The term “recourse debt” refers to the type of loan that makes the borrower personally liable for the entire outstanding loan balance. This type of loan requires collateral as it is a secured form of debt financing. In case of a default, the lender can take possession of the collateral and sell it to recover its losses.
The thing that is different in the case of recourse debt is that if the market value of the collateral is less than the outstanding loan balance, the lender has the right to seize the borrower’s other assets to make up for the remaining losses.
Features of Recourse Debt
The main features of recourse debt are as follows:
- Since it is backed by collateral, it is considered a secured loan.
- The terms and conditions of the loan are very flexible, given it comes with collateral.
- In the case of a default, the lender has the right to seize the asset offered as collateral.
- The lender also has the right to go for other borrower assets if the collateral doesn’t cover the outstanding loan balance.
How does Recourse Debt work?
The main feature of a recourse debt comes into play only when the borrower fails to honor the scheduled debt repayment, i.e., the borrower defaults. Then, the borrower is personally liable for the loan balance remaining after foreclosure of the asset provided as collateral. The lender can drag the borrower to the court to secure the pending payment using one of the following methods:
- Garnishment: The lender has the right to pay off the pending recourse loan by taking money straight from the payments coming into the borrower’s account or business.
- Collections: The lender may consider selling the pending loan amount to a collection agency to collect the remaining money from the borrower.
- Levies: The lender can legally claim the borrower’s other assets not provided initially as collateral in the loan agreement.
Examples of Recourse Debt
The following example will help understand the concept of recourse debt.
David is a US resident who recently got a stable job in a real estate company with a monthly salary of $10,000. He plans to purchase a house in New York City for $300,000. David saved $75,000, which he will use as equity in this purchase. So, he has to go for a house finance loan of $225,000 from a financial institution.
As per the bank, his credit records are not good enough for this amount of loan. So, based on his financial position and credit profile, the bank manager offered him a recourse debt. In this loan arrangement, the financed home will be provided as collateral, and the repayment will be taken from his monthly paycheck directly.
Let us assume that David defaulted on the debt payment the following month, and the lender seized the house for foreclosure, resulting in a debt recovery of $175,000. So, the remaining $50,000 (= $225,000 – $175,000) plus the interest cost will be recovered by directly deducting the amount from the monthly paycheck until the entire outstanding loan balance is settled.
This is how a typical recourse debt works in the case of a default.
Recourse Debt vs. Non-Recourse Loan
A non-recourse loan is also a secured form of financing, but it is inherently different from a recourse debt. Unlike recourse debt, the lender can only seize the collateral offered in the loan agreement if the borrower defaults on a non-recourse loan. This means that any outstanding balance after the foreclosure has to be written off by the lender. The primary difference between the two debt forms is the lack of personal liability in a non-recourse loan in the case of a default.
Advantages of Recourse Debt
Some of the significant advantages are as follows:
- Since it is backed by collateral and the borrower’s liability, the lender has to bear a relatively lower risk than any other form of lending.
- Borrowers with good credit profiles can get these loans at relatively favorable interest rates.
- Borrowers with poor credit profiles can also get these loans as they are perceived to be low-risk by the lenders owing to unlimited liability borne by the borrower.
Disadvantages of Recourse Debt
Some of the major disadvantages are as follows:
- In this type of loan arrangement, if the borrower defaults on the loan repayment, the lender can claim the borrower’s income stream to recover the pending loan amount.
- Sometimes borrowers become victims of predatory loan financing, where the lenders extend funds despite knowing imminent default owing to borrowers’ financial position.
Some of the key takeaways of the article are:
- Recourse debt is a loan type in which the borrower defaults; the lender is allowed to seize the collateral and other assets to recover the money.
- Other assets that the lender may seize include income sources, deposit accounts, etc.
- The primary difference between a recourse debt and a non-recourse loan is that the borrower is personally liable for the debt in the former.
- It is backed by collateral and the borrower’s liability, so the lender has to bear a relatively lower risk than any other form of lending.
Borrowers need to know what kind of loan arrangement they are getting before signing the agreement. It has many advantages both for the borrower and the lender. However, there can be severe consequences for the borrower in the case of a default. So, a borrower must decide after taking cognizance of all the aspects of a loan.
This is a guide to Recourse Debt. Here we also discuss the definition, features, working, and examples along with advantages and disadvantages. You may also have a look at the following articles to learn more –