Consequences of Defaulting on a Recourse Loan

In the event of default, recourse loans give the lender the ability to take back the asset pledged as security for the loan and the ability to collect any shortage there may be on the outstanding principal balance of that loan.

This differs from a non-recourse loan in which the lender's only recourse is to reclaim the item pledged as security. For example, a home loan pledges the home as security, and an auto loan pledges a specific automobile as security. In the event of default in these loans, the lender has the right to take back only the home or the car. 

Recourse loans carry with it more serious consequences when there is a gap between the value of the asset they take back and the remaining principal balance of the loan. In this case, the lender can seek to collect from you the value of that deficiency.

If you default on a home loan of $100,000 and the bank takes back your home and later sells it at auction for $75,000, the bank realizes a loss of $25,000. A recourse loan gives them the ability to collect the $25,000 deficiency in a number of ways. 

Lenders can take you to court and obtain a deficiency judgment; a legal action that allows them to collect the additional money you owe. This judgment can attach property you own including homes, cars, boats, retirement accounts, or any other personal property. It also gives the lender the ability to take and sell that property to satisfy that judgment.  Deficiency judgments will show up on your credit profiles as a derogatory item and will likely affect your credit score negatively.

Lenders can also apply to have your wages garnished. This consists of an agreement between the lender and your employer that specifies a portion of your paycheck be sent to the lender until the deficiency has been met.

Lenders may choose not to seek a deficiency judgment regardless of how much money you owe. They may instead issue a forgiveness of debt statement, which means they are writing off that amount you owe as un-collected or un-collectable. If this is the case, you are forgiven for that deficient amount, and you no longer owe that money to the lender. However, there may be tax consequences for that debt forgiveness. In residential owner occupied home loan situations, if the lender forgives you for more than two million dollars of debt (one million dollars if filing taxes separately) you will be liable for taxes on the amount forgiven. Current tax law provides that for debt forgiveness under those amounts no tax is due.

For commercial and business loans there is no minimum or maximum amount. Any debt forgiveness will trigger a tax consequence if the lender files the forgiveness on IRS Form 1099-C Cancellation of Debt.

It's important to note that each loan is different and supplies different procedures for collecting once default has occurred. States also have specific laws in regard to recourse and non-recourse loans; with some states preventing the use of deficiency judgments entirely. When in doubt, always go back to the original loan document, as it will spell out exactly what the recourse is, and how the lender can collect from you. If you are still confused you should seek the advice of legal and tax professionals.