What Is a Non-Recourse Loan and the Provisions Protecting the Lender?
The non-recourse loan has provisions that protect both the lender and borrower.
It is one of the many loans given by banking and financial institutions.
There are several other types of financing that are available to borrowers.
These are loans from formal and mainstream institutions such as banks.
One can also get a loan from informal places such as loan sharks and pawnshops.
Basically, all loans that are available boil down to either recourse or non-recourse loans.
You as the lender are keen to know how you can protect your money.
In most cases where the borrower fails to repay a loan, it is not pre-planned.
Unplanned circumstances and events may occur which the borrower had not foreseen.
Such events may hinder their ability to repay the loan.
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What Is a Non-Recourse Loan?
A non-recourse loan restricts the course of action that a lender may take.
The non-recourse loan is secure using different types of securities.
These may include properties and stocks.
The borrower does not incur any personal loss.
It also extends to partnerships or limited liability firms that have taken loans.
The directors of the partnership are free from having their personal assets attached.
This in effect means that the lender cannot touch other assets such as their homes and bank balances.
This is the situation even in the case where the full value of the loan is not fully recovered.
In reality, the lender will be holding the short end of the stick in such a loan.
On the other hand, the borrower goes home free.
There is no possibility of further loss.
Ponzi Schemes and Non-Recourse Loans
Ponzi schemes made the headlines a few years ago.
It was mostly for the wrong reasons.
Most of the Ponzi schemes revolve around the issuance of non-recourse loans.
Non-recourse loans have the potential to be misused in Ponzi schemes as is explained below.
The promoters of such Ponzi schemes offer loans that include the clause to walk away in case the borrower defaulted.
It starts with the unsuspecting borrower depositing a security which is usually a stock with the “Ponzi lender.”
The “lender” would then take the stock and sell it in the market for the maximum value that it could fetch.
The borrower would then get up to 80% of the proceeds while the “Ponzi lender” keeps 20%.
The interest rates are quite high and average at 7%.
This makes it difficult for most borrowers to repay the loan.
Since there is a provision to abandon the loan, most borrowers will do exactly that.
This is ideal for the Ponzi promoter.
There is no intention in the first place to give back the collateral that secures the loan.
The crooked lender does not intend to give back the security to the borrower.
The lender is simply unable to buy back all the shares that they sold.
The borrower in this instance will suffer a loss.
From the above, it is important that any potential borrower takes time to check the credibility of the lender.
It is advisable that you should confirm if the lender is genuine or not.
What Happens in a Typical Recourse Loan So That We Can Clearly Differentiate the Two?
A typical recourse loan involves two parties: the lender and the borrower.
They agree to sign the loan agreement with specific terms.
One of the terms is that the lender may pursue and attach other assets in order to recover the value of the loan.
This is beside the primary asset, security or collateral against the loan.
The option is to pursue other assets that include vehicles, bank balances, and stocks.
The lender in effect is telling the borrower that the full value of the loan given must be recovered.
This includes the principal sum plus the interest on the loan that disbursed.
Eventually, the lender will recover all their money.
The lender has to operate within legal limits.
This means not using illegal means to recover the loan.
It may involve filing a lawsuit in a court.
This is done so that the court will issue orders that aid in the recovery of the loan.
The loan sharks are well known to use means that are not lawful.
Which Loan Attracts Higher Interest Rates?
The non-recourse loan typically attracts interest rates which are quite high.
This is in comparison to non-recourse loans which have lower interest rates.
The risk is higher since the lender has fewer options to recover the loan.
The higher interest rates act more like a compensatory mechanism.
This is helpful to the lender so that they reduce the risk of losing their money.
The lender will mostly impose interest rates that are higher, knowing in advance that the loan could turn out to be a bad loan.
Loans disbursed as “recourse” have lower interest rates since they are less risky to the lender.
Who Takes out Non-Recourse Loans and Why?
The non-recourse loan is popular with real estate investors.
The loan limits the personal liability of the real estate investor in case the project goes belly-up.
The lender will loan against the real estate assets.
The lender considers the borrower’s past performance before the loan is given.
The loan may be for a new housing project.
Alternatively, the loan may be for repairing property already constructed.
In most cases, the investor does not plan to default on the non-recourse loan.
Events beyond their control may overtake them.
Another group of persons that prefer non-recourse loans is those with a poor credit rating.
They may opt to secure a loan with a higher interest rate with fewer questions asked.
This second group of borrowers would mostly obtain such a loan from a private lender.
The non-recourse loan makes it easier for a person who otherwise does not qualify for a loan in the mainstream banking institutions.
How Does the Element of Taxation Work out in Non-Recourse Loans?
When a property is being disposed in order to recover a recourse loan, it is assumed that the fair market value will be realized.
That is the assumption of the taxman.
The tax authority assumes that the lender gains nothing less than the fair market value when selling the asset used as the security.
Accordingly, this assumption forms the basis of the tax calculation.
In recourse loans, the lender may choose to forgive and write off a certain amount of the loan.
In the eye of the taxman, the ordinary income is liable to taxation.
When they suffer a personal loss in the recovery of the loan, the borrower may deduct it from their income when filing their tax returns.
The taxman considers non-recourse loans differently.
The lender is assumed not to sell the asset for the fair market value but rather to make-up for the shortfall of the loan balance.
Since there is no debt forgiveness in non-recourse loans, the borrower stands to lose since they cannot qualify for forgiveness by the lender.
The borrower who took out a non-recourse loan cannot qualify for capital gains or loss for the purposes of taxation.
How Is a Non-Recourse Loan Underwritten?
The non-recourse loan requires sound financial skills for the lender who is issuing the loan.
It involves the lender using financial models that help in structuring the loan.
The lender should adequately understand the underlying technical issues in the loan.
Most non-recourse loans are long-term in nature.
The loan may span a minimum of five years to ten years.
The capital required for a non-recourse loan is typically high.
It may run in the millions of dollars.
The projected income streams are uncertain in non-recourse loans.
What Are the Loan-To-Value Ratios of Non-Recourse Loans?
A loan-to-value ratio is a number used by lenders in setting the maximum loan amount that a borrower may receive.
It is analyzed by looking at the loan amount against the value of the security offered.
Securities such as stocks can have loan-to-value ratios that may reach a maximum of 90%.
This means that the borrower may borrow up to 90% of the value of the stock used as the security.
In non-recourse loans, the normal loan-to-value ratio is 50-60%.
This lower ratio is used with the consideration that there is a higher risk of non-repayment.
It is therefore intended to protect the lender in case the borrower defaults on repaying the loan.
6 Provisions That Protect the Lender in Non-Recourse Loans
These are: filing for bankruptcy, misrepresentation and failure to maintain insurance.
Others include the failure to pay taxes on property, environmental contamination, and bad-faith delaying tactics.
The six provisions that protect the lender in non-recourse loans collectively are referred to as “bad boy guarantees.”
Another term that is commonly used is “carve out” provisions.
They protect the lender in cases that involve fraud.
The provisions mentioned above afford protection to the lender when issuing non-recourse loans.
The following is an in-depth look at each individual item.
1) Filing for Bankruptcy
When the borrower files for bankruptcy voluntarily, the law steps in to help the lender.
It gives the lender the power to ignore the non-recourse clauses and pursue the borrower individually.
The law ensures that the lender receives the treatment that is equal to that of the borrower.
This protects the lender in the instance where the security offered is part of the valuation in the bankruptcy proceedings.
The lender in such a situation is able to seek recovery of the owed loan amount from the borrower at the personal level.
2) Misrepresentation and Fraud
The borrower is also liable personally, if it is discovered that there was willful perversion of facts when they were securing the loan.
The extent of the fraud may include the material misrepresentation when processing the loan or during the loan payment.
The information withheld will significantly alter the terms of the non-recourse loan.
In such a case, the lender can claim for the full amount of the loan.
This would be similar to altering the loan to the terms of a recourse loan.
3) Failure to Pay Taxes on Property
In the event that the borrower has not been paying property taxes and does not disclose this information, the non-recourse loan is liable to become a recourse loan.
Ideally, the property should have no tax liability.
If the lender discovers it has a tax liability, the lender can pursue the borrower.
In such a situation, the lender cannot pass off the liability of the property tax to the new owner.
At the same time, paying the property tax would reduce the income that would accrue towards them.
It would reduce the amount expected in order to offset the loan.
This violation of not paying the property taxes changes the terms of the loan.
The lender can claim the extra amount that is liable as the property tax from the individual assets of the borrower.
The protection that accrued to the borrower in the non-recourse loan becomes null and void.
4) Failure to Maintain Insurance
The failure by the borrower to maintain insurance on the property can result in the non-recourse loan changing to become a recourse loan.
The borrower has to maintain insurance over the duration of the loan.
This is a stipulation that is common in most non-recourse loans.
The borrower in this case benefits by not paying the monthly premiums on the security that they offer.
The monies that the borrower saves are considered as additional income from the security.
When the lender is disposing such a property and discovers that the borrower did not maintain insurance, they may pursue the borrower to recover the monies.
This in effect means that the loan is no longer considered as being non-recourse.
5) Environmental Contamination
In the event that the borrower did not disclose to the lender that the property has environmental contamination, the non-recourse loan terms are void.
The contamination could have been newly discovered or could be a long-term problem.
This information materially affects the valuation of the property used to secure the non-recourse loan.
In some instances, the property could be condemned to being demolished by the local authorities.
Such an action would put the lender at the risk of loss.
The law allows the lender to take remedial action to recover the full value of the loan in such case.
The remedial action may extend to attaching other assets of the borrower.
These are assets that were not initially included in the terms of the non-recourse loan.
6) Bad-Faith Delaying Tactics
The interference by the borrower will change the terms of the loan.
This changes the status of the loan to that of a recourse loan.
This interference by the borrower is taken to be done in bad faith.
The borrower may institute actions that are basically delaying tactics.
This may apply to the foreclosure of a property.
This is done so that the lender is unable to recover the non-recourse loan.
The law, in this case, will side with the lender.
It allows the lender to pursue remedial action that is similar to that of recourse loans.
The law will treat the loan as being no longer non-recourse but as recourse.
The interference may be from the guarantor or the property owner.
The lender may find it harder to recover their money in such an instance.
This is due to the actions of the borrower which are malicious.
This is normally done in bad faith by the borrower.
It has the effect of making the terms of the non-recourse loan null and void.
Word of Advice in Conclusion
As we conclude, a word of advice is necessary.
As in any type of loan, always start by considering all the options available.
If possible, seek advice from a financial planner, a broker or a bank.
The failure to plan ahead is disastrous for the borrower and lender when taking and giving out a loan.
The second thing that a borrower should do when considering a non-recourse loan is to undertake due diligence on the financial institution offering the loan.
Ensure that the institution is legitimate and bona fide.
The third important thing to do is to understand the terms of the non-recourse loan fully.
This applies to both the lender and the borrower.
Make sure that you understand the terms and provisions of the loan before signing on the dotted line.
This is important in protecting you as the lender or borrower in a non-recourse loan.