Recourse vs Non-Recourse Loans

What Is a Recourse Loan? 

A recourse loan is a popular loan option in India. Regardless of the form of collateral, the lender can take the collateralized asset, if you do not pay. Furthermore, the lender can go after your other assets or income if a sale of the collateralized asset does not cover the outstanding funds. Thus, the borrower has additional liability on the defaulted loan. Lenders tend to charge lower interest rates with recourse loans because lenders assume less risk. 

How do Recourse Loans work? 

When you borrow money under a recourse loan, you are typically pledging something of value, such as your home, vehicle, or business assets, as collateral for that loan. If you pay back your loan, then there is no issue. 

However, in case you are unable to pay the loan then, the lender will attempt to recover their funds through the sale of collateral you pledged. This means the lender can pursue your additional assets including your savings, additional property, pay cheque, or investments, may even file a motion and ask the court to take a small percentage of your salary until the debt is cleared.  

Example 

Let's take a simple example here:  

If you borrow Rs.50 lakh rupees with your home as collateral, and you default, the lender sells your home, and it only goes for Rs.40 lakh. The lender will automatically follow up for the remaining Rs.10 lakh which is no longer forgotten (written off). The lender can still enforce you with the remaining 10 lakh outstanding with any of your additional personal assets, including your car or salary. 

Benefits of Recourse Loan 

 The advantages for the Borrower include: 

1. Lower Cost: The lender has additional avenues to recover money in the case of a default. Thus, the cost of borrowing is often lower. 

1. Easier to obtain a Loan: Personal guarantees or collateral increase the lender's willingness to lend if the borrower's credit history is more moderate.  

1. Higher Borrowing Limits: Borrowers are allowed to access larger sums or borrowing terms than may be available with non-recourse or unsecured loan repayment contingencies.  

1. Flexible Terms of Repayment: Since the lender is incurring less risk, they may provide a more flexible repayment schedule. 

1. Credit History: Successfully navigating through the demands of a recourse loan can bolster your score. Your credit history can be strengthened and will make it significantly easier to draw on credit in the future. 

The advantages for the Lender are as follows: 

1. Stronger Recovery Rights: The lender has the advantage of compensation beyond the limits of any collateral. A lender can pursue the personal assets of the borrower which minimizes the lender's risk with recourse loans. 

1. Lower Default Risk: Knowing that the lender has multiple ways to recover in case of default encourages the borrower to pay in a timely manner.  

1. Flexibility in Lending: Recourse lending opens more avenues for lenders to lend money to borrowers, including small businesses and individuals with limited financial opportunity.  

1. Improved Portfolio Stability: Recourse loans are ultimately less risky for Banks and NBFC's, placing recourse loans in a strong position for a healthy asset portfolio.  

1. Lower Loss Potential: The lender potentially could recover if collateral has depreciated.  Either in full or close to full loan recoveries from the borrower. 

Disadvantages of Non-Recourse Loans 

Drawbacks of Recourse Loans for the Borrower are: 

1. High risk to personal assets: If the collateral isn’t worth the amount owed on the loan, the lender can seek to seize your savings, other properties, investments, or a portion of your salary. 

1. Potential for personal loss beyond the collateral: The borrower may quickly find out much more personal assets than in collateral to the lender. 

1. Credit Rating: To the borrower's disadvantage, defaulting on a loan can lower the borrower's credit score in most cases, which may also affect the borrower's access to credit in the future. 

1. Burdensome Litigation: If the borrower is unable to pay off the loan, the lender may commence litigation, garnish wages, or initiate some other legal action against the borrower to seek payment of the loan. 

1. Impact multiple Personal Assets: If the loan is sizable, or if the borrower has low liquidity, the borrower may potentially lose multiple personal assets for the loan. 

 The following are the drawbacks of Recourse loans for the Lender: 

1. Time-consuming Process: Even with the right to seek a personal asset, it may take a long time to recover the collateral. 

1. Cost of Collecting and Enforcement: The actual cost of recovery (legal fees, court costs, costs of assessing asset valuation) increases the effective cost of recovery of the loan. 

1. Possible Non-recovery or Non-collection: The borrower may not own enough assets, or their own assets are all encumbered and may even have declared a bankruptcy proceeding prior to recovering any collateral. 

1. Administrative Burden: Multiple different types of personal assets may be burdensome to track and recover, especially if the different assets are either separate or dispersed, or if the assets require further assessment to get to find out the real value of the asset. 

What Is a Non-Recourse Loan? 

Non-recourse loans operate in a different manner. The lender may only claim the collateral identified in the loan agreement. If the borrower defaults and the collateral’s value is insufficient to repay the loan, the lender cannot pursue any of the borrower’s other assets. This protects the borrower from losing more than what is pledged as collateral. Because the lender has more risk, non-recourse loans often carry higher rates of interest and generally have more stringent approval requirements. Such loans are also less common in India. 

How do Non-Recourse Loans work? 

You borrow funds secured by an asset or property with a higher interest rate in this type of loan. The most common collateral for the non-recourse loan is an asset that maintains value or provides stable cashflow. If you fail to pay the debt, even if the collateral sale produces a shortfall, you are not personally liable for the loan beyond the collateral.  

The bank incurs the loss, and you are not liable for reduced collateral receipts of sale with a non-recourse loan. Since the bank has a higher interest rate and more or stricter collateral requirements for this type of loan, it assumes more risk.  

Example  

To illustrate:  

You borrow Rs.40 lakh secured by a commercial property. You failed to pay, and the property (you pledged as collateral) was sold for Rs.30 lakh. The bank cannot pursue your other assets for the Rs.10 lakh shortfall. Your liability is limited to the value of the property, even if the entire loan balance is not recovered. 

Benefits of Non-Recourse Loans 

The following are the advantages of Non-Recourse Loans for the Borrower:  

1. Limited Personal Exposure: Your exposure is limited to collateral. Even if the loan isn't completely repaid, your other assets will be protected.  

1. Protection of Assets: If the asset pledged as collateral is insufficient to satisfy the amount of debt, the lender cannot take or seize your other properties, savings, or income. 

1. Possibility of Larger Loans: You may have access to larger amounts for a project or investment, with strong, high-value collateral, without putting yourself at risk.  

The advantages for the Lender are:  

1. Repayment Structure: The payment terms are often tied to the cash flow or income produced by the asset pledged as collateral. This makes repayment typically structured and predictable.  

1. Potential High Returns: Non-recourse loans tend to be used in larger commercial or infrastructure projects, and the returns can be significant depending on the success of the project.  

1. Asset-Based Risk Assessment: The lender may only need to assess the collateral housed in the project and project viability and may not focus on the borrower's personal financial situation.  

 Disadvantages of Non-Recourse Loans 

The cons of Non-Recourse loans for the Borrower are:   

1. Higher Borrowing Costs: Because the lender is assuming more risk on the loan, the interest rates, fees charged, and conditions for borrowing will likely be higher.  

1. Higher Borrower Qualification Standards: Only borrowers with significant collateral and project viability will be considered.  

1. Higher Degree of Complexity in Approval: If there is detailed due diligence and financial analysis to undertake, you can expect it to be more complex than typical loans. 

The drawbacks of a Non-Recourse Loans for the lender include:  

1. Higher Risk Exposure: If the collateral value decreases or the project fails, the lender may face a total loss of the loan amount. 

1. Dependence on Asset Quality: Recovery relies entirely on the collateral or cash flow generated from the project. 

1. Limited Legal Recourse: A lender is unable to pursue the borrower’s personal assets, and therefore, collateral or project failure could result in a total loss of principal without legal recourse.

When to Decide Between Recourse and Non-recourse Loans 

Select a Recourse Loan if: 

1. You wish to have lower interest rates, as lenders take less risk with these loans.  

1. You are comfortable using personal assets besides collateral, to qualify for a larger loan amount.  

1. You have an average credit profile, which will make it easier to get approved.  

1. You prefer flexible repayment terms, as lenders are more likely to permit different repayment schedules.  

1. The loan is for personal purposes, purchases such as home loans, car loans, or small business loans, when collateral is not an overwhelming concern.  

Select a Non-recourse Loan if: 

1. You want to restrict your personal liability to just the collateralized loan or specifically protect certain assets.  

1. You are financing large commercial or large public works projects, and loan repayment is expected to come from cash flows generated from the asset.  

1. You have high-value, stable assets that can not only be used as collateral, but lenders are comfortable relying only on collateral.  

1. You are comfortable with paying a higher interest rate or having stricter loan approval conditions to protect your assets.   

1. Your goal is to mitigate risk and not efficiently/higher interest rates. Also, the peace of mind to know your personal assets are protected may be worth a higher price. 

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