What happens if you default on a loan? In many cases, lenders can try to recoup their losses by taking any collateral you put up, including going after your paycheck or bank account. But a specific type of loan limits what lenders can do to collect.
With “nonrecourse” debt, the lender can’t go beyond collecting collateral.
Let’s take a look at some of the key differences between recourse and nonrecourse debt, and what the implications can be for your assets.
- Nonrecourse debt vs. recourse debt
- Recourse and nonrecourse debt laws vary by state
- Qualifying for nonrecourse debt
- Tax implications of nonrecourse debt
Nonrecourse debt vs. recourse debt
When you need to borrow money, you may have multiple loan types to choose from. Most fall into two categories: secured and unsecured. With a secured debt, the loan is tied to an asset, or collateral, that lenders can seize if you default on the loan. Unsecured debts do not use property as collateral to back the loan.
Both unsecured and secured personal loans can be recourse debt — meaning you’re assuming the risk and are personally liable. Depending on state law, if you default on a recourse loan your lender could try to collect the remaining amount owed, and in some cases they may be able to go after your wages or levy money from your bank account. For secured resource debts, if the collateral doesn’t cover the amount owed the lender could take additional actions to collect the remaining amount owed.
For example, assume you’ve taken out a recourse home equity loan for $200,000 and default on that loan, your lender can foreclose on your loan and sell your home (your collateral). If the sale only brings in $150,000, you’ll still owe the rest of the loan amount, or $50,000. With this type of loan, your lender could take further legal action, like filing a deficiency judgment, to try to recoup that difference.
Nonrecourse loans are a type of loan where the bank assumes more of the risk. With default of nonrecourse debt, after seizing any collateral the lender absorbs any unpaid balance.
If you take out a nonrecourse auto loan for $25,000 and can’t make your monthly auto loan payments, your car can be repossessed. But if your lender sells the car for $20,000 and you still owe $23,000 on the loan — you’re not liable for the $3,000 shortage.
In this case, your lender would not be able to file a deficiency judgment for that $3,000 difference. Instead, they’d simply swallow the loss.
Recourse and nonrecourse debt laws vary by state
Whether your debt is recourse or nonrecourse can depend on where you live, depending on state law.
In some states, certain loans are required to be provided as nonrecourse debt. For example, a state could require that all mortgages are nonrecourse debt. In these states, lenders aren’t allowed to pursue a deficiency judgment after collateral has been seized.
Qualifying for nonrecourse debt
Because nonrecourse debt puts more financial responsibility on the lender, qualifying for this type of debt can be harder — you may need high credit scores and a lower loan-to-value ratio. The interest rates on nonrecourse loans may also be higher to further compensate for the extra risk.
Check with your lender to see if it has a preapproval process for nonrecourse loans.
You may also want to consider meeting with a credit counselor. Check out our guide to credit counseling to learn more about whether it’s something that might help you.
Tax implications of nonrecourse debt
Depending on the kind of loan you have, you may still owe taxes on a portion of it if you default. The IRS treats recourse and nonrecourse debt differently.
For example, if part of your loan was canceled or forgiven, the IRS may view the canceled or forgiven amount as taxable income. But if the debt that was canceled or forgiven was nonrecourse, you’re in the clear from a tax perspective.
Using our home example from earlier, if your lender forgave the $50,000 deficiency on a recourse home loan, that $50,000 could be taxable. But in a nonrecourse situation where your lender cancels the remaining debt, you won’t have to pay taxes on it.
One other tax implication to note: If you’re dealing with a foreclosure and your lender sells your home for more than you owe, you might still owe tax on any gain from the sale.
If you live in a state that doesn’t require nonrecourse loans by law, you may want to check with your lender to see whether they’re offered.
For instance, if a bank wants you to personally guarantee a personal loan for your company, it could be a better financial move to look into getting a nonrecourse loan for your company instead. That way, you’re not putting your own personal assets at risk.