What is Non-Recourse Debt?
Non-recourse debt is a type of loan secured by collateral, commonly property. If the borrower defaults, the lender 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. A non-recourse debt does not hold the borrower personally liable for the loan.
Key Takeaways
- Non-recourse debt is a type of loan that is secured by collateral, commonly property.
- Lenders charge higher interest rates on non-recourse debt.
- Non-recourse debt is characterized by high capital expenditures, long loan periods, and uncertain revenue streams.
- A non-recourse debt does not hold the borrower personally liable for the loan.
Understanding Non-Recourse Debt
Non-recourse debt poses a greater risk to the lender than recourse debt, especially if the resale value of a loan’s collateral decreases below the owed balance throughout the life of the loan.
Conversely, recourse debt allows the lender to pursue 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. Both unsecured and secured personal loans can be recourse debts where the borrower assumes all risk and is personally liable. 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.
When a debt is non-recourse, the lender may liquidate the collateral but may not attempt to collect the deficiency balance. Non-recourse loans are a type of loan where the bank assumes most of the risk. 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.
Non-Recourse Debt Example
Imagine an auto lender loans a customer $30,000 at zero interest for a five-year loan to purchase a new vehicle. The new car’s value typically declines after the purchase. If the borrower stops making car payments after one year, the vehicle may be worth only $22,000, while the borrower still owes $26,000.
With the customer’s default, the lender repossesses the car and liquidates it for its full market value, leaving a deficient balance of $4,000. If the loan was a non-recourse loan, the lender assumes the loss.
When Is a Loan Issued as Non-Recourse?
Whether a debt is a recourse or nonrecourse loan often depends on state law. Some states may require that all mortgages be nonrecourse debts, prohibiting lenders from pursuing a deficiency judgment after collateral has been seized.
Who Can Qualify For a Non-Recourse Loan?
Because non-recourse debt poses a greater risk to the lender, a borrower may need high credit scores and a low loan-to-value ratio. The interest rates on non-recourse loans may also be higher to compensate for the risk.
How Are Liabilities Paid For a Recourse Loan?
After collateral has been seized, a deficiency judgment may levy the borrower’s bank accounts or garnish wages to repay the debt balance.
The Bottom Line
Non-recourse debt is characterized by high capital expenditures, long loan periods, and uncertain revenue streams. Underwriting these loans requires financial modeling skills and sound knowledge of the underlying technical domain. 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.
Related Terms: collateral, recourse debt, deficiency judgment, loan-to-value ratio, foreclosure
