If you are considering taking on a mortgage as part of an investment deal, you are taking on an additional liability should matters go south and you or your group can no longer make payments on the project. It is important to understand the difference between taking out a “recourse” loan and a “non-recourse” loan for these projects. This situation is different from taking out a loan on the primary residence where you plan to dwell, because you have less at stake in terms of your connection to the property. This article details the difference between the two types of loans and covers the role that private lending can play in both scenarios.
What is a “recourse” loan?
A “recourse” loan and a “non-recourse” loan differ with respect to the assets that a lender can repossess, should the loan go into default. In either case, there are available assets to seize, but let’s go over the difference. Another term for a “recourse” loan is a “personal guarantee.”With a “recourse” loan, if the sale of the property does not cover the balance due on the loan, you can go after the borrower in court to get the remaining balance. “Non-recourse” loans are commonly used for mortgages and other long-term loans. Because of the reduced capacity of the lender to recover the full amount owed, the interest rates on “non-recourse” loans tend to be higher.
Understanding a “non-recourse” loan?
A “non-recourse” loan includes only the security that is being used as collateral. So if the borrower does not make payments, the lender can go in and seize the property legally, and the lender can sell it to recover the balance due on the loan. However, the borrower does not have personal responsibility for the debt, so the lender can’t go after the borrower if there is debt remaining after the sale. “Non-recourse” loans are rarely extended to individuals. Instead, they are extended to single-asset ownership entities such as Limited Liability Companies (LLCs) or Limited Partnerships (LPs). The purpose of this is to protect the borrower’s other assets; the only asset associated with the entity would be the property against which the mortgage was taken. In Alberta, mortgages currently held in personal names with no corporate guarantors are “non-recourse”. This does not apply to other provinces.
Benefits of a “Non-recourse loan”
In addition to the reduction in liability as far as personal assets, there are several other reasons why a “non-recourse” loan is preferable to a “recourse” loan.
- With a “non-recourse” loan, borrowers can sell their shares in a commercial property underwritten by that loan and walk away from any future liabilities.
- Borrowers also have more benefits with respect to estate planning when investing in a “non-recourse loan.”
How can a borrower reduce “recourse” debt?
Lenders and borrowers often both prefer “recourse” loans. Lenders like the reduction of risk; borrowers like the lower interest rate. Some ways that borrowers can reduce their “recourse” debt is to increase the amount of the down payment to get better terms on the loan; agree to a loan with a shorter term; or add collateral to the deal, to decrease lender risk.
The majority of businesses attempt to stay away from “recourse” loans for real estate purchases and investments, but there are times when they have no alternative. Understanding the difference for purposes of asset protection is crucial.
When would a borrower want to take out a “recourse” loan?
As we mentioned, a “recourse” loan will generally offer a more generous interest rate – because the lender has more options should the borrower default. Most auto loans are “recourse” loans. If a borrower goes into default, the lender can seize the car and sell it at full market value. Because cars depreciate so much after purchase, it is likely that there will still be a balance due, and the lender then has the right to pursue the borrower to get the remaining balance, as well as any associated fees.
In cases involving commercial deals, borrowers sometimes have to choose “recourse” loans if their credit and/or asset profile is not sufficient to earn approval for a “non-recourse” loan application. This can end up paying off for the borrower if the loan never goes into default because of the reduced interest costs. However, default can end up turning into a long legal nightmare.
How can private lenders play a role in a “recourse” or “non-recourse” loan?
In some situations, borrowers have the means to pay back a loan – either through their other assets or through a clear path to success for the project that requires the financing – but they cannot satisfy the underwriting requirements of the bank or credit union where they applied. Instead of moving from a “non-recourse” loan to a “recourse” loan, some borrowers have had success changing over to a private loan. The interest rate is likely to be somewhat higher, but the risk profile for the loan remains comparable to that of a “non-recourse” loan, which means that the borrower would not have to provide a personal guarantee.
Want to learn more? Contact Us so that we can determine the options that apply to your situation before moving forward.