Recourse Loans vs. Non-Recourse Loan

At a certain point, many small business owners find themselves needing to take out a loan. Loans can help them gather the resources they need to build or expand their businesses before they can generate revenue. For example, a loan might help a new business secure office space or raw materials to begin producing their product for sale.

If you find yourself in need of a small business loan, you'll quickly uncover two main types of loans: recourse loans and non-recourse loans. Both types of loans allow business owners to secure needed funding. They also offer some protection for lenders, as they require borrowers to post something as collateral for the loan. However, some key differences exist between the two, which may impact the type of loan you qualify for or prefer.

We'll walk you through what you need to know about recourse loans versus non-recourse loans to help you navigate the borrowing process.

What Is a Recourse Loan?

A recourse loan is a loan backed by collateral. The borrower has personal liability for the full amount of the loan. This means that if you don't honor the loan repayments, the lender can go after your other assets if the collateral doesn't completely cover the remaining debt. Recourse loans are often preferred by lenders because they offer greater opportunities for lenders to protect themselves.

With a recourse loan, if you don't pay back the loan according to the loan documents outlining the original terms, the lender will first seize the collateral you put up for the loan. However, if they seize that collateral and sell it for fair market value (FMV), but it still doesn't cover the debt you have from the loan, the lender can go after your other assets to help them fully recuperate costs. This means they can seize other items you own, such as a vehicle, or they can sue you to garnish your wages to finish paying back the loan.

Since these loans give lenders more leverage and greater protection, recourse loans often have lower interest rates. This category of loan can also be more accessible for those who don't have a strong financial history that would establish them as a good candidate for another type of loan.

Recourse Loan Examples

You've likely already encountered recourse loans in your daily life. Lending institutions use this lending structure when giving out:

  • Auto loans
  • Credit cards
  • Certain types of real estate loans

What Is a Non-Recourse Loan?

A non-recourse loan is a loan where the borrower must post collateral, but if that doesn't cover the loan's full value, the lender is otherwise out of luck. In other words, with this type of loan, the favor goes toward the borrower.

With a non-recourse loan, even if the borrower defaults on their loan terms, their other assets and bank accounts remain safe from being seized by the lender. If you end up not paying a loan according to the outlined terms, your lender can't garnish wages or otherwise account for the full value of the loan beyond what the collateral can bring in. In this type of situation, the lender will have to accept the loss.

Since the lender has fewer protections with this type of loan, these loans often come with higher interest rates and may also be harder to obtain. No financial institution wants to risk losing money on loans, which means they will pay even closer attention to the credit history of borrowers before approving the loan.

Non-Recourse Loan Examples

Non-recourse loans can also be found in a variety of situations outside the small business environment. Here are a few places where you may have encountered this type of loan:

  • A traditional real estate or mortgage loan. If you don't pay your mortgage, the main course of action for the lender involves a foreclosure on the home to recuperate their losses. Some state law dictates recourse liability on mortgage loans, though.
  • Loans structured to allow businesses to use expensive business machinery or real estate as collateral for the loan may also represent a non-recourse loan.

What Is Recourse Debt?

Recourse debt is the money owed on a recourse loan. If a borrower fails to repay their loan in full, the bank or another lender can go after the borrower's other assets, such as garnishing wages. The terms of the loan dictate the options of the lender if the borrower defaults.

Since this form of loan requires less economic risk on the part of the lender, this type of debt is more common for many businesses.

As a small business owner, you'll want to understand that recourse debt holds you fully responsible for the amount of the debt. When you take out the loan, you'll need to put up some collateral. However, if you don't repay the loan and the value of the debt is greater than the value of the collateral, the lender can come after your other assets.

On the other hand, if you have non-recourse debt, the lender won't be able to pursue your assets beyond what you posted as collateral. If you used a physical property as your collateral in a real estate loan, for example, and you can't pay the debt, the lender can only foreclose on the property. They will then sell the property to make back as much money as possible on the debt.

You'll also want to note how this type of debt can impact you as a taxpayer. If you have non-recourse debt, lenders might sometimes not fully recuperate their costs, for example, if they sell a foreclosed house for $10,000 less than the amount left on the loan. Since the lender has no means to make up this difference, they have to forgive this debt. However, the Internal Revenue Service (IRS) will generally count the amount of debt forgiven by lenders as income for you. Therefore, if you had owned this property, you would have to report that $10,000 when filing your income tax.

Recourse Loan vs. Non-Recourse Loan: Which One Is Right for You?

As you begin to consider the type of loan that you want to take out for your business, you may wonder which type of loan will work best for you and your business. As a business owner, you should recognize that various factors will impact the type of loan you want and the type of loan you qualify for.

When to Choose a Recourse Loan

As mentioned, a recourse loan will offer greater protection for the lender. They know they have a greater chance of fully recuperating the amount of the loan, even if something interrupts your ability to pay. Therefore, they also offer lower interest rates than other types of loans.

The times when a recourse loan might work best for you include:

  • If your business credit is new or you don't have the best credit history. Providing banks or other lenders with greater protection for their own investment can increase the chances of securing a loan.
  • If you have a high debt-to-income ratio. A high ratio may mean lenders prefer to give you a recourse loan to protect themselves.
  • If you want to secure a lower interest rate. Lenders are more inclined to offer lower interest rates when they have the safety of loan recourse.

When to Choose a Non-Recourse Loan

Although benefits exist for borrowers with recourse loans — particularly the lower interest rate — there are also times when you might prefer to have a non-recourse loan. This can be particularly true for people who want to make sure their other assets won't be at risk regardless of their future income and ability to pay the loan.

The times when you might have the best chance of securing a non-recourse loan include:

  • If you have a strong credit history and credit score. The lender may feel more confident in the likelihood of repayment.
  • You don't mind paying a bit higher of an interest rate for the protection of your other assets.
  • You know you can meet the borrowing requirements outlined by the lender for a non-recourse loan.

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Notice to the Reader

The content within this article is meant to be used as general guidelines and may not apply to your specific loan or financial situation. Always consult with a professional accountant to ensure you're meeting accounting standards.