Several key things distinguish hard money loans from their conventional counterparts. Among them is how lenders deal with default. As a general rule, hard money loans are non-recourse loans. Do you know what that means? If not, keep reading.

For the sake of keeping things simple, I will compare a hard money loan used to purchase investment property against a typical conventional mortgage. The differences between these two scenarios are sufficient to explain the non-recourse principle.

Asset vs. Credit-Based Lending

The foundation for this discussion is asset versus credit-based lending. Hard money lenders follow the asset-based model. This means that the property being acquired acts as collateral for the loan. An approval decision is made based on the value of that asset.

Conversely, traditional mortgage lenders follow a credit-based model. They look into every detail of a buyer’s credit score, history, income, and debt load – all to determine the buyer’s ability to repay. The value of the home is only relevant to the loan-to-value ratio.

The Non-Recourse Scenario

Defaults occur in the hard money industry. They are unavoidable. But how lenders handle default is interesting. Most will contact the borrower and offer so much time – perhaps 30 days – to bring the account current. If the borrower fails to do so, the lender proceeds. Here is where the non-recourse principal comes in.

In a non-recourse scenario, there is no formal foreclosure preceding. The borrower simply relinquishes title to the property in question. This is both easy and possible because hard money arrangements typically transfer title to a third-party intermediary, like a title company. The intermediary acts as a trustee. In the event of default, the trustee can simply transfer the title to the lender.

The borrower forfeits the asset and that’s it. There is no further recourse. There are no payments to be made, no auctions to deal with, and no collection agencies looking for a balance due.

For the record, Salt Lake City’s Actium Partners says that hard money lenders don’t want to be landlords. They also do not want the hassle of having to deal with default. So they tend to work with borrowers to avoid it.

The Conventional Foreclosure Scenario

If you are still confused about non-recourse loans, understanding how conventional foreclosure works should clear things up. Imagine a bank foreclosing on a borrower who fails to make his monthly mortgage payments. The first thing the bank needs to do is file the proper notices with the county court.

The bank essentially has to petition the court for the right to seize and sell the property. But before that happens, the bank needs to give the borrower a certain amount of time to get caught up. Assuming the borrower fails to do so, the court then instructs the county sheriff to seize the property. It is then sold at a future auction.

Meanwhile, the title of the property remains in the name of the borrower. Because the bank has a lien on the property, any proceeds realized from the sale go to pay off the mortgage debt. A higher sale price could mean money left over money that legally belongs to the borrower. But – and here is the big thing – the borrower is on the hook for any remaining balance if the property does not sell at a high enough price to completely repay the outstanding mortgage.

Mortgage lenders have recourse to collect every penny due them in the event of default. Hard money lenders simply take possession of the asset in question and go on their way. That is what makes not-recourse loans different.