A lot of businesses reach a point in their operations when they feel the need to borrow money. Most business owners (and individuals) pay a visit to their local bank or credit union to take out a loan.
The problem is, taking out a loan might not be the best financial option for your business, even if you feel like you have the cash to make the payments. There are a lot of tools available to small businesses to help them reduce or avoid financial risks when borrowing money.
Most business owners know that there are two types of debt: secured debt and unsecured debt. The main difference between the two is that secured debt, such as a mortgage or student loans typically require collateral. Unsecured debt, however, does not require any collateral but often involve higher interest rates due to the higher risk posed on the lender. The most common type of unsecured debt is credit card debt.
The two common types of secured loans are recourse and non-recourse loans. In this article, we will do a deep dive in recourse loans, the differences between the two types, and how they can affect your business and how to reduce risks.
What is the Difference Between a Recourse and a Non-Recourse Loan?
As mentioned briefly above, the biggest difference between a recourse and a non-recourse loan is collateral. Most non-recourse loans involve using a property as collateral. If the borrower defaults on the loan, the lender can seize the property.
However, the borrower is not personally liable in the event of default. This means that if a borrower defaults on a loan, and if the value of the property used as collateral does not sufficiently cover the outstanding loan balance, the lender cannot legally pursue the borrower for additional compensation.
Recourse vs. Non-recourse Loans
On the other hand, a recourse loan allows the lender to pursue the borrower for the “deficiency balance”, which is the total amount of debt owed to the creditor after collateral has been liquidated. A lender may attempt to collect the deficiency balance by filing a lawsuit and obtaining a deficiency judgment in court.
One of the most common examples of recourse loans is an auto loan. For example, a lender may extend an auto loan to a customer for $25,000 to purchase a new vehicle. Because vehicles are notoriously known for significantly declining in value after driving off the lot, many customers end up owing more on the loan than what the vehicle is worth.
Therefore, if a customer defaults on a vehicle loan after only six months of payments, and the total amount owed by the customer is $24,000 and the vehicle is only worth $20,000, then the lender will seize the vehicle with a deficiency balance of $4,000.
Because most auto loans are recourse loans, the lender has the right to pursue the borrower for the deficiency balance. On the other hand, in the event the loan is a non-recourse loan, the lender will have to accept the $4,000 loss.
The Non-recourse Loan Underwriting Process
Both the borrower and lender assumes a portion of the risk involved in the agreement. Non-recourse loans are often characterized by high capital expenditures, long-term loan periods, and uncertain or inconsistent revenue streams.
As a result, a lender may set higher interest rates to offset the element of risk involved. The underwriting process for non-recourse loans requires experience and superior financial modeling knowledge.
How to Reduce Recourse Debt
There are some courses of action businesses can pursue to avoid or eliminate recourse debt, which includes:
- Consider the value of the asset. Is the risk associated with the asset low or nonexistent? Provide collateral with little volatility or even additional collateral to reduce lender risk.
- Make a higher down payment on assets. The bigger the down-payment is, the better your loan terms will be.
- Shorten loan terms. For example, instead of a loan period of 36 months, try to shorten it to 24 months (again, if possible and financially feasible).
It is important for both individuals and businesses to understand the differences between secured and unsecured debt, as well as recourse and non-recourse loans in order to make more informed financial decisions.
While it’s best for businesses to avoid recourse in business operations, sometimes it’s your only option. Implementing a solid business operation and maximizing cash flow options are the best possible ways to avoid recourse loans and to ensure that your business is financially stable for future growth.