The term “recourse” is something that pops up from time to time when someone is taking out a commercial loan. What exactly is “recourse”?
Recourse in lending is a term that is used when a lender can hold a party responsible for loan payments. Let’s take a look at some typical transactions to better understand this concept, but first, let’s look at the parties to a transaction and some other definitions.
A Promissory Note, or note for short, is the borrower’s promise to pay a loan.
Depending upon the type of property and state in which the transaction takes place, the document that pledges a property as collateral is known as the security agreement, mortgage, or deed of trust. We’ll discuss these in much more detail in another video.
The Borrower is a person or entity that is taking out a loan. They are primarily responsible for making the payments on that loan.
A guarantor is a person or entity that is signing on as a secondary payer on a loan that is accepting responsibility for paying a loan should the borrower default. Commercial banks usually require a small business owner to sign on as a guarantor when their business takes out a loan. That way, if the business, or borrower in this instance, doesn’t pay, the bank has “recourse” against the business owner who has signed as a “guarantor”…meaning they can go after the business owner for payment.
A Hypothecator is a person or entity that is offering up property that they own as collateral for a loan. Hypothecation is simply the act of offering up that property as collateral, also known as security. The hypothecator is the person that would sign the mortgage document, deed of trust, and/or the security agreement.
Now, let’s go through a few examples.
John owns 123 Plumbing. 123 Plumbing wishes to take out a business loan against the building that is in 123 Plumbing’s name that the business operates out of. In this case, 123 Pluming is the borrower, but they also are the hypothecator as they are offering up their building as collateral. The bank might require John to sign as a guarantor as well. This is called a “Recourse Loan” as the lender would have recourse against the guarantor, in this case John, should the borrower, in this case 123 Plumbing, fails to pay.
Perhaps the bank is not requiring John to sign as a guarantor. In this case, the loan is a “Non-Recourse Loan. If 123 Plumbing were to default, the lender could exercise their rights against the borrower, 123 Plumbing, but they couldn’t come after John personally for payment. They could, or course, still exercise their rights against the collateral property, but not John personally as he was no one was a guarantor on this loan.
Now let’s throw in a curve ball. Let’s say John, the owner of 123 Plumbing, wanted to buy a machine for $10,000 and went to the bank for a loan. John’s father, Bill, offered to put up a truck that Bill owns as collateral for the loan. In this instance, 123 Plumbing would be the borrower, the bank might require John to be the guarantor, and Bill is the hypothecator. In the event of a default, the bank has recourse against John as the guarantor, but they could only exercise their rights against the property that Bill hypothecated as collateral. Bill was not a guarantor in this instance, so they have no recourse against Bill personally…only his collateral.
Most commercial banks will require owners of businesses to sign as guarantors on loans. The exceptions to this are usually when the borrower is a publically traded company, a non-profit, or in many instances where the loan is on larger, income producing real estate. Most fix-n-flippers or small business owners are going to be required to guaranty loans from commercial banks.
Let’s give you another interesting scenario that we see a lot. John wants to purchase investment real estate in his IRA. It’s important to note that John and John’s IRA are two totally different entities. Many people don’t know that an IRA can actually borrow money, BUT it according to IRS regulations, the loan must be Non-Recourse to John. John’s IRA can borrow the money, but John may not guaranty the loan. If there is a default, the lender can exercise their rights against John’s IRA and the collateral that John’s IRA has hypothecated, but John can have nothing to do with the transaction.