What is a Non-Recourse Loan?
A non-recourse loan limits the assets of a borrower that a lender can pursue to recover the loan amount in the event of default. If the borrower defaults on the loan, the lender can only go after the asset(s) that were designated as collateral for the loan. The lender cannot go after other assets, such as the borrower’s personal accounts, in order to recover the total amount of the loan.
- Non-recourse loans put the responsibility on the lender: if the borrower defaults, the lender can only claim the asset(s) covered by the loan.
- Non-recourse loans are harder to obtain and qualify for because the lender takes the majority of the risk.
- Most non-recourse loans come with the “bad boy carve out” caveat, meaning if the borrower is negligent or misrepresents themselves, the loan automatically becomes a recourse loan.
Non-Recourse Loans vs. Recourse Loans
Non-recourse loans, as described above, mean the lender can only go after the asset(s) covered by the loan itself if the borrower defaults. They are most often loans involving property. If the property is established and generating some type of income – for example, if the property is an apartment complex with monthly rental earnings – it may be fitting for the lender to keep the property and continue bringing in monthly rental payments. The lender may also wish to sell the property. In any event, the lender may not obtain any assets from the borrower in the event of default other than the assets pledged as collateral for the loan.
Recourse loans, on the other hand, place all of the responsibility on the borrower. If the borrower defaults on the loan, then the lender has the right to seize any asset(s) used as loan collateral and also to go after the borrower’s other assets and personal accounts. The lender may even be able to have the borrower’s wages garnished until the remaining debt has been paid.
Obtaining Non-Recourse Loans
Clearly, the majority of the risk and exposure with non-recourse loans rests with the lender. If the asset used as collateral decreases in value while in the possession of the borrower and the borrower defaults, then it is the lender’s obligation to come up with the money that is lost.
Therefore, non-recourse loans are much more difficult to come by and qualify for. Commercial lenders will often only extend non-recourse loans to finance certain types of properties and only to especially worthy borrowers. Stable finances and an excellent credit score are two important factors that a lender looks at before considering a non-recourse loan.
Another major factor considered? The earning history/potential for profit of a property. The lender must take into consideration what the property was used for, what it will be used for, and where it’s located, among other things.
Regardless of the abovementioned factors, because of the sheer risk to lenders, non-recourse loans carry a higher interest rate than recourse loans to compensate the lender for the additional risk.
Bad Boy Carve Outs
Lenders do have one advantage when offering non-recourse loans – something called “the bad boy carve out.” The bad boy carve out refers to a clause attached to almost all non-recourse loans. In the event that the borrower conducts any fraudulent activity or misrepresents themselves in any way, the non-recourse loan becomes a full recourse loan and the lender can then go after any of the borrower’s assets in a case of default. Activity that can trigger the bad boy carve out clause to take effect includes:
- Declaring bankruptcy intentionally
- Falsifying their financial strength/ability to repay the loan
- Not maintaining the adequate amount of insurance coverage on the property
- Not paying property taxes
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