Thursday, December 4, 2008

Recourse and Non-recourse Home Mortgages

A home mortgage is secured by the property. The mortgage provides the lender the right to foreclose on the property in the event the mortgage payments are not made. Suppose the home sells at foreclosure for less than the outstanding balance on the mortgage? With a non-recourse loan, the lender may not come after the borrower for the remaining amount. With a recourse loan the borrower is responsible for any outstanding amount still owed after the sale of the home. Most homes are financed with non-recourse loans; however, this differs by jurisdiction. Moreover, in some markets the first mortgage may be non-recourse, while second mortgages may be recourse loans. The state laws governing home mortgages can be found at As always, the information should be checked with a lawyer in your state.

When debt is forgiven, it is generally taxed as income. However, the IRS has special rules when home mortgage debt is forgiven because of a non-recourse mortgage. The amount forgiven reduces the cost basis in the home.

Martin Feldstein has argued that non-recourse home mortgages give the homeowner too much of an incentive to walk away from the home when housing prices drop. He maintains that this has contributed to the current mortgage crisis. To alleviate the drop in home prices, he believes the government should offer to refinance a share of each homeowner’s mortgage at a substantially lower interest rate. In return for the lower interest rate and smaller monthly payments the borrower would be obligated to repay a full-recourse loan. The government loan would be a full-recourse loan that could not be discharged in a personal bankruptcy. Such a mortgage would eliminate the potential incentive for default and stem the rising tide of foreclosures. There is no doubt that the sale of foreclosed property has contributed to the decline in housing prices. The WSJ reports that the sale of distressed properties accounted for 35% to 40% of transactions in the third quarter. You can go to Freakonomics for a discussion of this proposal.

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