What is Non-Recourse Debt?

Definition: Non-Recourse debt or nonrecourse debt is a loan that are secured by a given collateral. This debt instrument is typically backed by an asset, frequently a real estate property.

What Does Non-recourse Debt Mean?

Contrary to recourse debt, which holds the individual personally liable for the loan; non-recourse debt is guaranteed by certain collateral. In the scenario of a borrower’s default the collateral must be liquidated to cover for the outstanding debt balance, freeing the borrower from the responsibility to pay any difference that may arise between the collateral’s liquidation value and the remaining balance of the loan. Non-recourse debt normally has a higher interest rate than recourse debt, since the risk taken by the lender is bigger. The nature of the collateral can vary, but real estate is the most frequently employed.

Nevertheless, financial assets, machinery and other equipments can be used as collateral for non-recourse loans. Mortgages are common examples of non-recourse debts. In order to protect themselves, lenders normally finance less than 80% of the commercial value of the property. The recent subprime crisis unfolded many cases where non-recourse debts were granted for the entire value of the property. When house prices started to decrease and clients started to default the lenders experienced heavy losses because the asset value was way less than the current balance of the mortgage.

Example

Quick Cash Co. is a company that provides loans to small businesses. The company normally grants non-recourse loans and they offer to take machinery, inventory and even automobiles as collateral. The company’s business model has been successful since they lend 50% or less of the appraised value of the property. They have a low default rate and the few cases they get, they normally make a profit selling the asset in the open market.

Recently, the company increased the maximum percentage of the loans to 60% of the appraised value of the collateral, and this increased income coming from interests by almost 40%. Since the default rate didn’t increase, the company concluded it was a good strategy.