Key Takeaways
- Secured by collateral, both recourse and non-recourse loans can be used to finance future purchases.
- The key difference between these two types of loans is what assets a lender can and cannot go after in case a borrower defaults.
- Investors should consider taking out non-recourse loans to protect their assets, in case a loan default occurs.
Becoming well versed in different types of loan options is not only a gateway to more opportunities, but can also serve as a means of asset protection. Non-recourse loans, in addition to recourse loans, are instrumental loan options every home owner or investor should be versed in. Most importantly, potential home buyers should understand the distinct differences between non-recourse loans and recourse loans. It is in your best interest to find out how the choice between these two loan options might affect your business and its assets, and how you can use non-recourse loans to your advantage.
What Is A Recourse Loan?
A recourse loan is a type of loan through which, in the case of a default, a borrower is financially liable for any outstanding debt balance. As a type of secured loan, recourse loans require collateral, which is typically the asset being financed, such as a house or a car. In case a borrower defaults on the loan, the lender can repossess and resell the collateral asset. However, if the current market value of the collateral is not sufficient to satisfy the balance of the loan, the lender has a legal right to go after the borrower’s other assets, such as additional real estate investments or vacation homes. They may even garnish wages or levy bank accounts until the debt is satisfied.
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What Is A Non-Recourse Loan?
A non-recourse loan, contrary to a recourse loan, does not allow the lender to seize additional assets when taking legal action against a borrower. This type of loan is also typically secured, where the lender can repossess and resell the collateral in case of a default. However, if there remains any outstanding balance on the loan after this action, the lender must absorb the cost. Thus, the borrower is not held personally liable for the additional funds owed. For business owners, this provides protection from having assets and other financial resources seized by lenders, aside from the collateral.
It is important to note that borrowers are not completely without possible penalties. Non-recourse lenders typically include provisions that allow them to go after a borrower’s assets in several cases: fraud, misrepresentation, bankruptcy, and failing to pay for insurance or taxes on the asset.
Recourse Vs Non-Recourse Loans
Both recourse and non-recourse debt are secured, meaning collateral is still required to get your loan approved. This collateral is typically the property for which the loan is financing. For example, if a borrower finances a purchase through either type of loan and defaults, the lender can seize and resell the collateral property in order to recoup at least some of the balance owed.
As mentioned previously, the key difference between recourse vs non-recourse loans, as they pertain to default, boils down to what assets a lender can or cannot go after. When an individual signs a non-recourse loan agreement, they understand the lender cannot go after personal assets other than the collateral property. Under a recourse loan, the lender is personally liable to repay the lender in full upon default.
Another differentiation between a non-recourse and recourse loan is the type of borrower associated with each. Because non-recourse lending presents a greater risk to lenders, home buyers with better credit are more likely to qualify. Recourse loans present a lesser risk for lenders, enabling them to lend to those with less-than-perfect credit scores, and at more affordable rates. Individuals with poor to fair credit can sometimes qualify for non-recourse financing in exchange for a premium interest rate. Borrowers’ credit scores will be negatively impacted by a default, regardless of the type of loan.
How To Use Non-Recourse Financing To Your Advantage
Investors wondering how to best go about purchasing real estate with non-recourse financing should consider the use of a self-directed individual retirement account (SDIRA). Before considering this option, it is first important to understand how individual and self-directed retirement accounts work.
Individual retirement accounts (IRAs) are financial investment accounts that allow individuals to save up for retirement in a tax-advantageous environment. IRAs are used to invest in mutual funds, stocks and bonds, but typically do not permit investing in other types of assets, such as real estate. Instead, investors can set up an SIDRA, which allows for the purchase of real estate as a retirement savings vehicle, yet still offers the same tax advantages as an IRA. According to the Investment Company Institute, there was a total of $9.2 trillion saved in U.S. IRAs by the end of the first quarter this year. Just two percent of this figure is represented by SDIRA accounts, implying how few Americans are aware of this investment option, as cited by the Washington Post.
Upon setting up an SDIRA, an investor can apply for non-recourse loans to finance real estate purchases. Any eligible individual can apply for a non-recourse loan with or without a SDIRA, but having this type of account provides the tax advantages enjoyed by IRA holders. Some of these tax benefits include tax-deferred income, as well as tax-free accumulation and tax-free withdrawals of investment gains. Before pursuing this financing option, however, there are some things to keep in mind:
- Not all lenders offer non-recourse loans or allow SDIRA real estate purchases.
- The SDIRA account must have enough funds available to pay for closing costs, as well as maintain reserves at all times.
- All income and expenses associated with the investment property must be paid from the SDIRA reserves.
- Investment properties must produce income, and must have a positive cash flow after all costs are accounted for.
Summary
Although no one wants to plan for defaulting on a loan, it is wise to understand potential consequences in the event an investment goes south. However, the good news here is that some types of loans offer more protection than others. As discussed, knowing the difference between recourse loans and non-recourse loans will help investors finance a real estate purchase in a way that mitigates risk as much as possible. By obtaining a non-recourse loan through a self-directed retirement account, individuals can purchase real estate with peace of mind, knowing full well that their other assets will remain under protection.
Did you know that you can use a self-directed individual retirement account (SDIRA) to finance a real estate purchase? Let us know in the comments below:
