Non-recourse Loans: The Collateral Loan That Limits Your Liability
A collateral loan is one secured by something that a borrower owns. Usually, when a borrower uses collateral, the lender needs some added assurance that he will receive full payment for his loan. To get that assurance, he asks for an asset, real estate, equipment or a car, for example, that he can claim if the borrower does not repay the debt. The lender can then sell the asset to recover his investment. Looking for Cruise Loans?
There are two types of collateral loans: a nonrecourse and a recourse loan. Each carries the risk for the borrower that its name implies. Every borrower should be honest with himself about what he is willing to risk for a loan if he cannot repay it.
What is a Nonrecourse Loan?
Nonrecourse loans are collateral loans that give a lender no power to come after any borrower assets beyond the collateral the borrower has offered. This means nonrecourse loans protect borrowers against any further collection efforts, even if the value of the collateral is less than the value of what is owed.
Often the collateral is a house or other property that the borrower has secured money from the lender to purchase. If the collateral is a house, the lender can seize the house if the borrower defaults. One of the concessions a borrower usually makes on nonrecourse loans is the agreement not to use the same collateral for other loans.
Companies that make nonrecourse loans have high capital costs, meaning their fixed expenses that make them operable are high priced, which are different that a commercial loan or a SBA Loan. These companies also have revenue flows that are not constant. The items a borrower may purchase with a nonsecure loan usually have a long loan period. All of these factors spell high risk for the lender, who has more to lose than the borrower. These same companies may also offer accounts receivable loans and hard money lending.
Each state has different laws for determining whether loans can be nonrecourse loans or recourse loans. It is difficult in California, for example, for lenders to pursue borrowers personal assets because California is a nonrecourse loan state. What if the state is a recourse loan state?
Recourse loans are a greater risk for borrowers because of the personal liability involved. If a recourse loan borrower does not repay his debt, the lender can sue him for the remaining amount of the loan. The borrower’s bank accounts can be seized and his wages can be garnished. In fact, the lender can continue to take legal action and come after personal assets until the debt is settled. This could mean years of financial challenges for a borrower.
Why Does a Borrower Seek a Nonrecourse Loan
One of the most common reasons that borrowers seek approval for nonrecourse loans is to purchase investment real estate using a self-directed individual retirement account, or IRA, as collateral. Property purchased this way is considered as another form of retirement investment, and it receives all the tax shelter benefits that an IRA does. It allows self-directed IRA owners to diversify their investments without tying up all of their IRA funds. The IRS requires the financing for these types of purchases to be nonrecourse loans.
Borrowers also get nonrecourse loans to refinance a mortgage for a lower interest rate and a shorter loan period. This is especially true for homeowners who have adjustable rates on their mortgages. They minimize the risk that their rate could increase and their homes would no longer be affordable.
The nonrecourse loan as a refinance option is attractive for other reasons, as well. If a homeowner has two mortgages, the nonrecourse loan allows him to consolidate his loans and make only one payment. Those who already have equity in their homes could use this loan to get cash for other purposes like home improvement or unexpected medical expenses.
A third reason a borrower may seek this type of loan is when he is the plaintiff in a settlement case. The money that a plaintiff, the borrower, receives is an advance percentage of the money that he believes he will receive in the settlement. Many consider this type of nonrecourse loan predatory. Typically, if the plaintiff loses the case, he will owe the lending company no repayment. This is the risk the lender takes with this kind of investment.
However, the reality is that these kind of loans are frequently offered to plaintiffs who do not have great credit or many valuable assets. These plaintiffs take an amount of upfront cash that is small compared to the settlement reward. When the plaintiff wins the case, he has usually given away such a large portion of his settlement that the lender walks away the winner. The plaintiff wins the case, but the lender wins the bulk of the money.
Tips for Securing a Nonrecourse Loan
One of the best approaches to the nonrecourse loan is to shop around. Many borrowers make the mistake of signing for the first loan offer they receive without comparing loan terms with those of other lenders. In some cases, while a loan is in the process of approval, the interest rate drops even more than when the loan process first initiated. Most borrowers do not know they they can still ask for the lower rate. Many lenders will discourage this and respond that the borrower’s rate is already locked. Until the loan is finalized with signatures, however, the rate is not officially locked in.
It is also important to make sure the loan is not a recourse loan. Borrowers should read all the loan terms and know the laws of their states. Borrowers should also know that there have been special circumstances that have allowed nonrecourse loans to be treated as full recourse obligations. Lenders have been allowed to ignore the nonrecourse stature of a loan if the borrower commits intentional acts like fraud or misrepresentation. In these cases, lenders could pursue deficiency judgments against borrowers to recoup losses from defaulted loans. Two recent legal battles in Michigan courts found in favor of the lenders, and this may set the tone for similar cases involving nonrecourse loans.
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