Most lenders require small business borrowers to provide collateral and a personal guarantee. But if you’re looking for a loan that doesn’t require both, you may want to consider nonrecourse financing. With this type of loan, the lender assumes the risk beyond the value of the collateral you provide. If you default and the collateral doesn’t cover the balance, the lender can’t come after your personal assets.
“Nonrecourse loans, most of the time, are tied to the assets the lender just secured,” Matthew Gillman, CEO of SMB Compass, told business.com. “If you have a shopping center and default, the lender takes the property back. Normally with a nonrecourse loan, you don’t have a personal guarantee.”
Nonrecourse loans are a way to mitigate the risk to the borrower, but they often have higher interest rates and require a higher credit score.
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What is the difference between a recourse loan and a nonrecourse loan?
Lenders break loans into two buckets: recourse and nonrecourse. With a recourse loan, the lender has the right to pursue you for the total debt owed. That means the lender gets your collateral, and if you owe more, the lender can go after your assets, including through a lawsuit. Examples of recourse loans include car loans and short-term real estate loans. [Need a business loan? Check out the best options for business lending.]
With a nonrecourse loan, the lender can liquidate your collateral but can’t go after your assets if there is a remaining balance. A mortgage is an example of a nonrecourse loan; the lender can only stake a claim to your home if you can’t pay your mortgage.
How does a nonrecourse loan work?
Nonrecourse loans are most often tied to real estate purchases, such as an office building, a warehouse or a storefront. But nonrecourse loans are also used for long-term business expansion projects. The business owners provide the lender with a plan that lays out the construction costs and the projections for growth from that investment. Repayment of the loan begins when the asset is operational. If it generates no revenue, the lender doesn’t get paid. If the business owner defaults, the lender can only go after the collateral, which, in this case, is the property.
There is a stipulation known as a “bad-boy carve-out,” which means the loan will no longer be nonrecourse if the borrower files for bankruptcy voluntarily, misrepresents themselves or engages in fraud, among other actions.
When would a business need a nonrecourse loan?
Nonrecourse loans aren’t used for working capital or payroll. Rather, business borrowers typically take out nonrecourse loans for projects that have long lead times, such as purchasing a property, building a warehouse or expanding a business through a long-term project.
Nonrecourse loans aren’t for every business owner. They involve more stringent underwriting, which means you’ll need a good credit score and substantial collateral.
Who offers nonrecourse loans?
Nonrecourse loans for business purposes are risky for lenders, which is why they aren’t a popular product at a wide variety of financial institutions. However, some banks and alternative lenders provide nonrecourse loans.
What are the pros and cons of nonrecourse financing?
Nonrecourse loans aren’t for everyone, but they can be a viable way to fund a long-term project. Before you decide if this type of financing is right for you, consider the pros and cons:
Pros of nonrecourse financing
- No mixing of personal and business. A rule to live by when running a business is to keep your business and personal finances separate. Nonrecourse financing protects you against that, at least on the loan side of your finances. If you default, you won’t have to worry about the lender coming after your house or personal assets or dragging you through a costly court case. The lender takes the collateral, and you walk away, which, in turn, lowers your personal risk. It’s the leading reason business owners choose nonrecourse loans.
“Whenever there’s an opportunity for a nonrecourse loan, it’s always better to not sign a personal guarantee,” Gillman said. “It limits your exposure in the event you default.” It’s important to weigh the lack of a personal guarantee against the cost of the loan, however; if it’s more expensive and you are confident you’ll pay it back, a recourse loan may be a better option.
- Faster underwriting. A nonrecourse loan is quicker to underwrite because the collateral is the asset you’re borrowing money for. With a recourse loan, the lender looks at the business deal, the borrower’s credit and the assets being used as collateral. With nonrecourse financing, the lender doesn’t have to underwrite the collateral.
Cons of nonrecourse financing
- High interest rates. Nonrecourse loans typically have higher interest rates than recourse loans because the lender is taking on more risk.
“With a nonrecourse loan, the more collateral you put up, the more guarantee the lender has,” said Nishank Khanna, chief marketing officer of Clarify Capital. The riskier the loan is, the higher the interest rate will be, Khanna said.
Khanna pointed to a term loan as an alternative in which you don’t have to put up collateral. But because that is a recourse loan, you’ll need to provide a personal guarantee.
- High credit score requirement. Even if a lender is willing to offer nonrecourse financing, it wants to ensure the borrower can pay it back. That’s why these loans require borrowers to have, at the very least, a strong credit score. The more creditworthy you are, the easier it is to get a nonrecourse loan. Some lenders offer nonrecourse loans to borrowers with less-than-stellar credit scores, but the interest rates are often much higher.
Most of the time, “borrowers can’t grow their revenue enough to pay that loan off,” Khanna said.
- Proof of experience. Typically, lenders offer nonrecourse loans only to borrowers who have a proven track record or a positive reputation within the industry. If you want to use nonrecourse loans for a real estate business, you usually have to prove yourself. If a lender does extend a nonrecourse loan to an unproven borrower, the lender usually requires a lot of equity to lower the loan-to-value ratio. The more experience you have, the less risk there is to the lender.
- Lower loan amounts. In addition to charging a higher interest rate on the loan to make up for the potential risk, nonrecourse lenders can be stingy with the money they’ll lend you. For example, you might want to finance 80% of the purchase with a nonrecourse loan, but the lender might do only 65%.
“Everything is a give and take with a nonrecourse loan,” Gillman said. “Sometimes, nonrecourse lenders may want a higher interest and decrease the amount of leverage they are willing to give.”