Recourse Debt Meaning
Recourse Debt is one of the types of loans which is less risky for a lender for investment, as having this loan gives the lender a right to recover its investment using the collateral asset if the borrower is unable to make its promise payment or outstanding liability which is specified into a loan agreement. Also if the current market value of the borrower’s collateral underlying assetsUnderlying AssetsUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. is not enough to recover outstanding loan then as per the recourse agreement lender can claim for other assets of the borrower which were not initially used as collateral.
Recourse Debt Example
The loan agreement will specify whether the loan is recourse or non-recourse.
Mr. Brian Pinto is a United States resident and recently got a stable job in a pharmaceutical company which gets him a monthly paycheck of $8,000. Mr. Pinto planning for buying a house in New York City for $250,000. Mr. Pinto has a saving of $50,000, So he went to a financial institution to look what are options available for him to obtain the loan of remaining amount $200,000 for his house financing, and also his credit records are not enough for this loan.
So after understating the scenario bank manager offered a recourse debt to Mr. Pinto which specified that under loan agreement the financed home will be kept as collateral and taking some percentage of his paycheck directly as a monthly installment payment. Since he had no other option available to get a loan, he accepted the offer from the financial institution.
What if Mr Pinto Stop Making Payment?
As mentioned above, home financing is a recourse debt and specified in the loan agreement.
Options to Recover Money for Recourse Debt
- Collections Notice: The lender might send you notice asking for money or the lender may sell the debt to a collection agencyCollection AgencyA collection agency refers to a firm engaged in the recovery of the default loans or dues from the borrowers on behalf of the lenders or creditors. A loan provider or creditor outsources its debt-collection function to such a third party to reduce bad debts. that will try to collect.
- Take and Sell Collateral: Firstly, the financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. will take the collateral property which is mentioned in the loan agreement, and sell the property to recover their outstanding loan balance.
- Paycheck Garnishment: If the current market value of the collateral is not sufficient to recover the outstanding loan balance then as per loan agreement the financial institution may get the right to increase the percentage of the paycheck or might contact borrower’s employer to take money out of his paycheck until all outstanding loan balance is recovered.
- Other Assets Attachment: In some cases, a lender might take and sell the borrower’s other assets which are never pledged as collateral. For example, the lender may take money from the borrower’s bank account or fixed deposits, etc.
Options to Recover Money for Non-Recourse Debt
(if the above-mentioned debt is financed under Non-recourse)
Non-recourse debt is secured by collateral assets. The only difference here is if Mr. Pinto defaults on the loan payment then the lender can only claim to the collateral asset which was pledged initially in the loan agreement and lender cannot seek any further compensation even if collateral assets are not sufficient to recover outstanding loan balance. For the lender, it is riskier to give non-recourse to a less creditworthy borrower but if they do, the lender charges high interest on the loan to compensate the risk associated with the loan.
In the Non-recourse debt, sometimes the borrower purposely defaults on the loan payment when the total outstanding loan balance is greater than the value of the assets pledged as collateral. This is also known as Strategic Default by borrowers.
Advantages of Recourse Debt
Some of the advantages of recourse debt are as follows:
- Less Risky for Lenders: Recourse is backed by collateral assets as well as a personal asset of the borrower so the lender has less risk as compared to a non-recourse.
- Low-Cost Loan for Borrower: High creditworthy borrower can enjoy low-interest rates on recourse as compared to a non-recourse loanNon-recourse LoanA non-recourse loan is one in which the borrower must attach some form of collateral security to the loan contract, such as property, equipment, or bank fixed deposits, in order for the loan to be approved. In the event of default, the lender has the right to seize the collateral in order to clear the dues..
- Leniency Loan in Process: Borrower with poor credit history can also get a loan from financial institutions as under recourse loanRecourse LoanA recourse loan is a form of loan in which the lender has the right to recover the whole amount loaned to the borrower if the borrower fails to pay. To collect the whole amount granted, the lender can seize not only the asset for which the loan was granted, but also additional assets of the borrower. reduces perceived risk associated with less creditworthy investors.
Disadvantages of Recourse Debt
Some of the disadvantages of recourse debt are as follows:
- Borrower’s Personal Income Garnishment: Under this type of debt, if borrower defaults on the loan then lender can claim on the personal incomePersonal IncomePersonal income refers to the total earnings of the individuals and households of a nation through multiple sources such as salary, wages, business profits, bonus, investment returns, dividends, rental receipts, employer contribution in provident or pension funds, etc. of the borrower such as wages, commission, bonuses, pension benefit, bank deposits, etc.
- Low-Interest Rate: Lender charge low-interest rate for recourse debt as compared to the non-recourse as this more security to the lender in case borrower default on the loan payment.
Important Point to Remember
- It is important to understand the terms of the loan initially.
- Recourse debts favor the lender.
- Non-recourse debt favors the borrower.
- For the good creditworthy borrower, a recourse can be beneficial as he can enjoy a low-interest rate on the loan.
When an individual or small business looking for the loan, usually there are two types of loans are available i.e. Recourse and non-recourse debt and the primary difference between these two types is whether or not the borrower’s personal liability for the loan payment. Under the recourse agreement, the lender can go after the borrower’s personal assets if pledged collateral is not enough to recover the outstanding loan balance. Wherein under the non-recourse, a lender can claim only to the collateral pledged initially if the borrower’s default on the loan payment.
This has been a guide to recourse debt and its meaning. Here we discuss the options available to recover money from recourse and non-recourse debt with examples. You can learn more about Corporate Finance from the following articles –