Recourse Loan Vs. Non-Recourse Loan: The Top 5 Differences

All secured loans require collateral. The borrowers pledge an asset as collateral to get the loans. In case of default, the borrowers have the right to seize the collateral pledged. That is the reason, lenders prefer tangible assets with high market values. In many cases, borrowers default on a loan.

The collateral often does not fully recover the remaining amount of the loan. The legal actions associated with a default after a foreclosure differentiate a recourse and non-recourse loan.

Recourse Loan gives lenders the right to seize the pledged asset. In case of default, lenders can also go after any other asset or income source of the borrower.

In a non-recourse loan, the lender cannot seize any other assets other than the pledged one as collateral.

Most conventional bank loans work as recourse loans. Similarly, most mortgages and home equity loans work as non-recourse loans. Nature and legal rights associated with both types, make them totally at odd ends as the preference for both parties.

Some key differences in both types of loans are:

FeatureRecourse LoanNon-Recourse Loan
Parties in ContractBorrower and LenderBorrower and lender
CollateralPledged and other assetsOnly pledged asset
Borrower liability:Personally liableNot personally liable
Interest CostsLowerHigher
Credit RequirementsLowerHigher
Preferred byLendersBorrowers
Total costsLowerHigher

1) The Claim by the Lenders

In case of default on a loan, the legal claim on the assets held by the borrower makes the primary difference. The pledged asset or source of income remains at stake for both types of loans. However, in many cases, the pledged assets cannot recover the remaining balance of the default loan.

A recourse loan gives the lenders a right to seize any assets of the borrower in case of default. The lender may recover the remaining loan balance from other sources of income of the borrower.

In a non-recourse loan, the lenders can only seize the pledged asset only. If the market value of the pledged asset remains lower than the recoverable amount, the lenders do not have the right to seize any other assets.

In other words, the borrowers are personally liable for default in a recourse loan only.

2) Credit Score Requirements

This leads us to the secure nature of both loan types. With more powers to the lenders, a recourse loan becomes less risky. A non-course loan is less secured for the lenders. Lenders always prefer secured loans over non-secured loans. Hence the credit score required for a non-recourse loan will always be higher.

Lenders will accept somewhat lower credit scores in a recourse loan if the borrower possesses substantial assets. These assets do not offer much to lenders in a non-recourse loan though.

3) Interest Rates

As we all know, lenders certainly charge higher interest rates with non-secured loans. A non-recourse loan offers less security to the lender, hence they charge higher interest rates. Contrarily, the interest rates will be lower for a recourse loan.

The total interest costs associated with a loan depend on some other factors too. For example, the central bank interest rate (LIBOR) plays an integral part in determining the total interest costs of a loan. However, the prime interest is decided by the lenders on the nature of the loan.

Borrowers will be better off in recourse loans as far as the interest rates are concerned. Although, borrowers risk more assets with recourse loans in case of loan defaults.

4) Collateral Value and Credit History

Some assets depreciate in value quickly. These pledged assets for loans offer risky options to the lenders. For example, in an auto loan, the market value of the car significantly falls the moment car hits the roads. For that reason, an auto loan will almost always be a recourse loan.

Lenders will demand stricter conditions with a non-recourse loan. A lower debt-to-income ratio, high market value of the asset, and clean credit history. Thus qualifying for a non-recourse loan will be more difficult for the borrower.

So if the credit score of the borrower is lower, the lender would ask for a high-value asset as collateral. In other words, with a lower credit profile, the lenders would prefer a recourse loan.

5) Tax Considerations

The tax implications for both types of loans can vary depending on the foreclosure type. If the lenders can recover the full remaining balance of the loan after a foreclosure, there will be no repayments. In most cases, the loan forgiveness balances occur in a recourse loan.

The lenders return the forgiveness loan amounts above the remaining loan and legal charges, which may result in a tax bill for the borrower.

Any proceeds after the collateral seizure and loan forgiveness are usually considered taxable income for the borrowers.

Limitation of short-term loans

A short-term loan is a type of loan that businesses obtain for temporary needs. Individuals can also get short-term loans to fund emergency expenses or expenses of temporary nature. Short-term loans can be an easy way to finance activities or operations that will generate high returns. They can also be helpful when individuals or businesses have cash flow problems but expect inflows shortly. Similarly, the entity acquiring the short-term loan can also benefit from the flexibility of payments that comes with short-term loans.

Short-term loans are a good option for small businesses or startups to obtain quick finance. Usually, that is because receiving short-term loans doesn’t require them to provide an asset as collateral. Similarly, short-term loans can also be beneficial for individuals who have a bad credit rating or do not have any credit history. Overall, short-term loans are easier to obtain and, therefore, better suited to particular entities.

While short-term loans can be highly beneficial for entities, they also have some limitations for both businesses and individuals. These are listed below.

Higher interest rates

While short-term loans are easier to obtain, they also come with a higher interest rate as compared to long-term loans. It is one of the main limitations of short-term loans for entities. As mentioned above, short-term loans are more suited to small size entities or individuals that do not have a credit rating or credit history. Some of these businesses may also not have proper resources to meet the interest demands for short-term loans.

The reason short-term loans come with a higher interest rate is because of the risks involved with them. While short-term loans are less risky as compared to long-term loans because of the shorter duration, they still are risky. The risks that financial institutions providing short-term loans must face is due to the high risk of default. It is because financial institutions provide these loans to entities that don’t have a credit history or satisfactory credit ratings. Therefore, the risks associated with default increase significantly.

Higher instalment repayments

Short-term loans may come with a more flexible repayment schedule, but they also come with higher instalment repayment requirements. It is mainly because short-term loans spread over a shorter amount of time as compared to long-term loans. Therefore, financial institutions will require their loans repaid quicker. Higher instalments can cause businesses to budget for these payments. It means that these instalments can harm their budgets, especially for small size businesses or startups.

Early payment penalties

The main return for the financial institution providing short-term loans is the higher interest rates that borrowers have to pay. In case the borrower returns the loan earlier than the agreed-upon time, the lender loses the ability to profit off the short-term loan. In these cases, the financial institution may impose conditions that disallow early repayment or discourage it. Sometimes, these conditions may also come in the form of penalties. The penalty will compensate the lender for the lost profits but may end up disadvantaging the borrower.

Limited finance

One of the other disadvantages of short-term loans is the limited finance entities receive. While short-term loans are a great way to fund temporary cash needs, entities cannot use them for any big projects. The finance provided through short-term loans are significantly lower as compared to long-term finance. If borrowers are looking for a type of finance to fund large projects, they may have to look into other types of loans as opposed to short-term loans.

Force entities into borrowing loop

Short-term loans are readily available for every type of entity to obtain, regardless of whether they can repay the loan or not. There are no checks that financial institutions make before giving out short-term loans. That means some entities that may not have the ability to repay loans may also get loans. For those entities, short-term loans can force them into a borrowing loop. It means when they can’t repay the loan, they will obtain more loan to pay the previous loan and so on.

Negative impact on credit score

This disadvantage of short-term loans is related to the ability of the borrower to repay the loan. As mentioned above, short-term loans come with higher costs and higher instalments, which can affect the ability of the borrower to repay the loan. Therefore, it can end up harming the credit score of the borrower instead of improving it. It also affects some main ratios of a business, which can deter its ability to attract investments or obtain more loan.

Conclusion

Short-term loans are loans used to finance temporary activities. Short-term loans can have some benefits such as better flexibility or easier obtainability, but they may also come with some disadvantages. The main disadvantages of short-term loans are that they require higher interest payment and higher instalment repayments. They may come with early payment penalties as well, and only provide limited finance, as compared to long-term loans. Likewise, they may force entities into a borrowing loop and negatively affect their credit score in case of default.

Limitation of medium-term finance

The length of finance received by a business can dictate many factors related to it. These factors may include the amount of finance received, the interest rate or return the business must provide for it, the repayment schedule, etc. It also means that the business must decide beforehand how much and for how long it requires finance. Usually, the most common options that a business has are short-term and long-term finance, when it comes to the length of finance.

Short-term finance is the type of finance a business requires for temporary activities. These may include funding working capital needs or meeting temporary cash shortage problems. Short-term finance, as the name suggests, spans for up to 2 years. Short-term finance comes with higher interest rates and a busier repayment schedule as compared to long-term finance.

Long-term finance, on the other hand, is the type of finance that a business requires for long-term needs and operations. For example, it may obtain long-term finance to finance expansion projects or acquisitions. Long-term finance consists of any finance with a length of 5 years or more. Usually, these may include long-term loans or owners’ equity. Long-term finance may come with lower interest rates and a relaxed repayment schedule as compared to short-term finance. However, in the long run, they are more expensive for business.

Another option that the business may have is medium-term finance. While not as common as the above two types, it is still an option that it can use for specific purposes.

Medium-term finance

Medium-term finance consists of any finance that the business receives for a period between 2-5 years. The main purpose businesses use medium-term finance is to finance expansion projects or purchase fixed assets. However, as compared to long-term finance, these projects may be of lower capacity. Similarly, businesses that expect higher returns from projects in a short amount of time may also prefer medium-term finance over long-term finance. Usually, medium-term finance only includes loans or other debt instruments, as equity is long-term finance. Medium-term finance, as compared to the other two options above, can have advantages and disadvantages for the business.

Limitations of Medium-term finance

The limitations of medium-term finance for a business include the following.

More difficult to obtain

Medium-term finance is more difficult to obtain as compared to short-term finance. That is because the financial institution, or lender, providing the loan will generally require the business, or borrower, to meet a specific credit rating. The finance may also come with some other requirements from the lender. For borrowers that do not have the required credit score, medium-term loans may not be an option. Similarly, some types of medium-term finance may require the business to offer a collateral for in exchange for the loan. For small businesses and startups, that may not be possible.

Longer approval process

Due to the extra checks on the borrower, medium-term finance may have a long and lengthy approval process as well. Apart from the checks, lenders may also require some other extensive documentation that supports the financial capacity of the business to repay the loan. For small size businesses and startups, this may take even longer due to no credit histories. Therefore, medium-term finance can be disadvantageous for those businesses looking for quick ways to finance activities. Similarly, the lengthy process does not guarantee a borrower will receive the loan. So, the borrower always faces the risk of waiting through the process and not obtaining a loan at all.

Higher fees and penalties

Some forms of medium-term finance may also come with high fees and penalties. They may consist of origination fees, which includes costs which the lender incurs due to the processing of the information related to the borrower. However, the lender charges the borrower for this cost. Similarly, the penalties include prepayment penalties, which is the penalty that the lender charges the borrower if the borrower pays the loan before the specified maturity. Prepayment penalties are less common as businesses are less likely to return finance before the specified time. However, they still exist in medium-term finance.

Accrued interest

Medium-term finance may also result in high accrued interest for the borrower. The accrued interest depends on the interest rate of finance. Accrued interest generates when the finance spans over several years. Accrued interest makes finance more expensive as compared to a short-term loan. Accrued interest is a common problem with long-term finance as well.

Conclusion

Businesses can obtain finance for different periods. Most commonly, they use short-term and long-term finance. However, they can also use medium-term finance, although it is not as common. Medium-term finance consists of funds that businesses receive for 2-5 years. They use these funds for specific purposes. The limitations of medium-term finance include difficulty to obtain, longer approval process, higher fees and penalties, and accrued interest.

Advantages of medium-term finance

When it comes to financing for businesses, there are many options available. A business can use different sources of finance, such as equity and debt, to finance its activities. These are the two main types of finance that are available to businesses. While each source may have its advantages and disadvantages, it is for each business to decide which source is right for its requirements.

A business, apart from deciding which source of finance is necessary to meet its requirements, must also decide how long it needs finance. Usually, finance can be short-term and long-term. A business can use short-term finance to fund temporary cash shortages or short-term operations. Short-term finance generally refers to finance that spans between 1-2 years. On the other hand, it can use long-term finance to fund large, long-term projects. Long-term finance is finance that lasts for five years or more.

However, these aren’t the only two options a business may have available. It can also obtain medium-term finance. Medium-term finance is generally rarer than the other two types of finance. It spans over 3-5 years. Usually, a business uses medium-term finance for specific purposes, for example, when long-term finance isn’t available or for deferred revenue expenditures. Medium-term finance can come with advantages of both short-term finance and long-term finance, but may also inherit their disadvantages. Medium-term finance mostly consists of loans because equity is generally a long-term source of finance.

Advantages of Medium-term Finance

The main advantages of using medium-term finance for a business are as follows. As mentioned above, most of these advantages relate to loans because medium-term finance does not contain equity.

Regular repayments

Medium-term finance comes with a regular repayment schedule that is straightforward to understand. A business must make repayments on a monthly or biweekly basis in this type of finance. Regular repayments make it easier for businesses to predict expenses, which can also help with budgeting. It can also help them manage their cash flows accordingly. The terms of medium-term finance are preset in the loan contract between the financial institution and the business acquiring the loan. 

Fixed interest rates

Apart from the fixed repayment schedule, medium-term finance also comes with fixed interest rates. The interest rate is a part of the contract for the finance and, therefore, predetermined. A fixed interest rate has the same advantage as regular repayments. It helps a business in budgeting and cash flow management. Fixed interest rates also make calculating the interest payments for each period straightforward, as the same interest rate applies over the life of the finance. It also helps the business understand how much the finance costs.

Credit score

Medium-term finance is a great way for businesses to improve their credit scores, especially ones with a bad credit history or credit rating. Due to the regular repayments and interest rates, businesses understand how much they need to pay and budget for it accordingly. That means it can make it easier for them to predict payments and make them on time. By receiving and repaying the finance on a timely basis, a business can improve its credit scores. Improved credit scores can be highly beneficial for businesses and can help them secure finance with better terms in the future.

Higher loan amounts

Using a medium-term loan can also give business access to a higher amount of loan as compared to a short-term loan. The business also receives the loan in a short period, thus, making it easier to plan activities and start operations using the received funds easily. With medium-term loans, a business can receive as high as $500,000 in cash. For some small and medium-sized businesses, this amount is enough to start projects and continue operations. Since the loan also spans over 3-5 years, the higher loan amount should also be straightforward to repay.

Less risky for lenders

Medium-term loans can also be beneficial for lenders. Usually, lenders require the borrower to have a good credit score before providing the loan. It allows lenders to mitigate their risks associated with default on repayments by the business. That is also the reason why medium-term loans are easy to obtain for the borrower. The lower risk for lender also translates to better terms for the borrower such as lower interest rates, as already mentioned above.

Conclusion

Businesses need finance form different sources to fund their operations. The finance may come from various sources, such as equity or debt. They also need to decide the length for which they require the finance for along with its source. Usually, finance can come for either short or long-term. However, some types of finance may also come for medium-term. Medium-term finance may have a lot of advantages, including regular repayments, fixed interest rates and improved credit score. Businesses can also obtain a higher loan using medium-term finance. Medium-term finance is also lower risk for the lender.

Advantages of Short-Term Loans

Introduction:

Whether as a business or an individual, we all face financial crunches from time to time. A short-term loan during such period of financial struggles can go a long way. A short-term loan can be defined as borrowing money for a period of six months to twelve months.

Now, a business may need a short-term loan during low season sales, to meet daily expenses, to expand and grow, and more.

An individual, on the other hand, may need a short-term loan to cover an unexpected expense.

Whatever the case may be, following are the advantages of borrowing a short-term loan:

1) Quick Approval:

Short-term loans are usually acquired for quick cash to meet unforeseen expenses. Hence, one characteristic of short –term loans are that they’re approved rather quickly than long-term loans, which require a long application process before being approved.

2) Easy To Acquire:

For individuals and startup businesses who do not have an excellent credit score, and banks might not agree to lend long-term loans to them, short-term loans are a life saver.

Since short-term loans are not obtained for huge amounts, there is lesser risk and hence, are easily granted to people even with a poor credit score.

3) Lesser Interest Is Accrued:

As the name suggests, short-term loans are granted for short periods. As compared to long-term loans with lower interest rates that accrue interest over 10 to 30 years, you actually end up paying lesser interest on short-term loans.

Because even though the interest rate is high, you only pay it over a year or half, and end up actually saving money in the long run.

4) Lower Interest On Mortgages:

Short-term loans do not usually have lower interest rates but in case of mortgages, several mortgage loans offer lower interest rates for short-term. This way not only do you accrue interest over a shorter period of time but also pay a lower rate of interest.

5) Comes In Handy During Emergencies:

Whether you’re a business or individual, short-term loans can save you from liquidity problems during emergency situations.

For a startup business, cash flow and capital means everything since the revenue isn’t generated up to maximum capacity. A startup business requires money to meet day-to-day operational expenses, or to even expand the business little by little. In such cases, short-term loans are a lifesaver since they’re quickly available for you to face any liquidity problems the market will throw at you.

For an individual, short-term loan can “literally” be a lifesaver in case of unexpected medical expenses. If you or your family member needs urgent surgery, or someone you know meets with an unfortunate accident, and you don’t have a lot of savings on hand, a short-term loan can be obtained since it gets quickly approved.

6) Improve Your Credit Score:

The credit score algorithm is made such that obtaining short-term loans boost your credit rating. It is quite difficult to build up a credit score if you’re a startup business or have just moved to the US, and since no one wants to lend you money, you have no idea where to start.

So, short-term loans can be a way for you to start building up your credit score since some lenders are willing to grant you money but at higher interest rates.

Once your credit score has improved, you can later easily obtain long-term loans and that too, on lower interest rates.

7) Predictability:

Short-term loans are acquired for a year or less. You are almost certain what your financial situation will look like in the next 12 months.

In case of long-term loans, you never know what your financial stability will look like in the next 10 to 30 years. However, for short-term loans, you can easily determine whether you’ll be able to pay back the lender with the current employment and income.

8) No Collateral Is Required:

Short-term loans do not usually require collaterals. Hence, you do not need to have a property or house to ledge as collateral to the bank for short-term loans.

9) Lower Stress:

Since short-term loans are paid off in a short time and you don’t have to live a decade or two of your life worrying about interest and principal payments, short-term loans comparatively cause lower stress than long-term loans.

Conclusion:

Short-term loans can be helpful for both businesses and individuals. It can be quite a convenient and helpful source of finance if you have the ability to pay back the loan on time along with the determined interest.

Sources of Loan

Overview

While beginning or extending a business, you may need to get finance and budget. Usually growing a small business requires getting cash. From conventional moneylenders, for example, large institutional banks, to innovative loaning stages, for example, crowdfunding sites, you can locate the correct source of financing for your small business.

Businesses take some tough time getting affirmed for conventional loans. Before taking out a business loan, you will presumably need to explore both customary and elective sources to locate the best fit for your business.

Variables to Consider before Deciding Source of Loan

Cautiously contemplate the type of finance as it could influence your tax obligations and income.

Before sourcing money:

  • Determine how much money you will require
  • Develop a sound business strategy
  • Consider the time period you should repay the loan
  • Determine your capacity to pay the loan

Sources of Loans Include:

1) Large Institutional Banks

Large institutional banks have commonly recognized names and typically work from one side of the country to the other or worldwide level. Established organizations with great credit and solid income are the best clients for large banks.

Benefits

  • Due to their size, they frequently have the most lending programs accessible.
  • Their sheer volume of clients implies they can normally offer good interest rates

Drawbacks

  • They are inflexible with their loan endorsement necessities.
  • The corporate office is generally in a major city far away.
  • If your business has a remarkable circumstance, you will experience difficulty getting before a real leader to discuss it.

2) Community Banks and Credit Unions

Community banks and credit unions contribute adaptability and an incredible client care. Community banks are organized like institutional banks, just they are smaller and serve locally. Credit associations are nonprofit organizations.

Benefits

  • They allocate their revenues to customers as lower financing costs on loans and better profits on deposit accounts.
  • A local bank can offer you frequent sit-down and meet sessions with the decision-maker on a personal level.
  • Benefit in marginal circumstances where you miss the mark concerning the bank’s approval measures.
  • By disclosing your circumstance to the decision-maker, you might have the option to turn a “no” into a “yes.”

Drawbacks

  • You have to provide an annual fee to become a member
  • Credit unions generally have less physical areas — occasionally a single branch.
  • As they are nonprofit and the aim is to minimize the expenses, credit unions can be delayed to put resources into innovation

3) Credit Cards

A credit card can be considered something used for individual costs, yet many are customized for organizations. Business Mastercards commonly allow you 90 days to pay before collecting interest rather than 30 days.  

Benefits

  • Discounted loan fees on significant buys.
  • Credit cards are extremely adaptable
  • Offer a credit extension rather than a fixed sum of borrowed money.
  • You can dunk into it as per the situation.

Drawbacks

  • Interest rates normally are a lot higher than for bank advances, and if you make even a single installment late, your rate can rise steeply.

4) Family and Friends

Loved ones are another possible wellspring of assets. If you have relatives or dear companions with cash to save, and you have hit out with other financing sources, you should think about moving toward them for help.

Benefits:

  • You do not have to round out a usual long application or debate on the benefits of your business’s financial reports.
  • Most loved ones loan your business cash since they care about you and need you to succeed, not on the grounds that they consider it to be a venture opportunity.

Drawbacks:

  • It can cut off fellowships and strain familial associations.
  • Potential aftermath that could result from a most dire outcome imaginable in which you can’t reimburse the assets.

5) Crowdfunding Sources

With crowdfunding, gatherings of outsiders meet up, each promising cash to subsidize an independent business, charity, or cause. A large group of online hosts exists to associate those looking for subsidizing with those hoping to contribute.

Benefits

  • The adaptability to set your own reimbursement terms.
  • Some stages urge individuals to give without anticipating money related pay in return.

Drawbacks

  • There are no assurances if individuals will support your business
  • You may break your subsidizing objective, you may get half of the route there, or you may have nobody vow cash. 

Conclusion:

Different kinds of business loans or aid will come with variable demands. By researching each one and understanding its pros and cons, you can find the best funding source for your small business.

Numerous entrepreneurs seek after one or various wellsprings of financing to begin, grow, or continue their organizations. By being educated and paying attention one can decide where to get their financing.

Various sorts of business loans or financing will accompany differing necessities. By exploring every one and understanding its upsides and downsides, you can locate the best source of loan for your independent business.