Recourse is a concept that applies to loans in default. Whether a loan involves recourse or nonrecourse debt determines which avenues are available to the lender when trying to collect the unpaid portion of the debt, and what steps the debtor can take to protect his assets during the process.
A loan is in default when the borrower fails to make payments within the time frame specified by the loan contract. Although loans almost always have a specific due date, merely missing this date does not automatically result in default. If a contract states that you must make a monthly payment on the 10th of every month, for instance, a check that arrives at the lender's offices on the 12th may simply result in a late payment fee, without being considered an “event of default.” The payment must usually be substantially late for the lender to conclude that the borrower has defaulted. If the contract signed between the lender and borrower does not have a specific clause that states what constitutes default, the decision is up to the courts, which will consider legal precedent as well as the specifics of the case.
“Collateral” refers to any assets pledged as security in order to borrow funds. In the case of a mortgage loan, your house is the collateral. While you have the right to live in it, you cannot sell the house without the consent of the lender. Large companies may pledge factories, heavy equipment or office buildings as collateral when borrowing from banks. Such loans are known as "secured loans," because the lender can confiscate and sell the collateral in the event that the borrower defaults.
A prudent lender will carefully assess the value of the collateral to ensure that it’s worth at least as much as the loan. When you borrow money to buy a house, for example, the value of the house usually has to exceed the loan amount. The value of the collateral may go down, however, as happened in most of the United States during the 2008 real estate crisis. In such cases, selling the asset may not cover the unpaid balance on the loan (particularly if the default occurs soon after the borrower took out the loan, when the majority of the debt is still unpaid). In the case of a recourse debt, the lender can sue the borrower for the unpaid portion of the debt after selling the collateral. In other words, the bank can foreclose on your house to collect the $250,000 you still owe on your mortgage, sell it to the highest bidder for $230,000, and then sue you for the remaining $20,000. In case of a recourse debt, the lender can sue the borrower for the unpaid portion of the debt after the collateral has been sold. In more practical terms, the bank can foreclose on your house to collect the $250,000 you still owe on your mortgage, sell it to the highest bidder for $230,000 and sue you for the remaining $20,000.
If a debt is of the nonrecourse type, the lender can only confiscate and sell the underlying property, or collateral. Even if this sale does not cover the entire unpaid balance on the loan, the lender cannot sue the borrower for the unpaid portion. Whether mortgage loans are recourse or nonrecourse depends on state laws, as numerous states make it illegal for mortgage loans to include recourse debt. In other types of debt, such as business loans, the contract signed between the parties determines whether the loan is recourse or nonrecourse.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.