Debt financing is a key tool for borrowers (investment sponsors) looking to fund projects without tying up their own capital. While this blog is written with borrowers in mind, it’s equally valuable for investors, especially those acting as lenders, to understand how these arrangements work. Understanding both sides of the equation creates stronger, more informed partnerships.
What is debt financing, and why should I care?
In this world, you can either pay for something with your own money or someone else’s. Most purchases, like groceries, gas, or your dog’s favorite toy, are made using your own money. But there are plenty of situations where you might choose to use someone else’s money instead. When you do that, you’re taking on debt. Debt is simply an obligation between a third party lender (you), and the borrower (investment sponsor).
Why would I take on debt?
Debt can be taken on for a multitude of reasons. Debt is typically taken on when a borrower (investment sponsor) has an idea for a project but does not have liquid capital available to allocate for the project. They may have certain liquidity constraints that limit their ability to shell out funds as needed or maybe looking to spread out their liquidity across multiple projects. In either scenario, or the many other reasons that may cause one to not allocate their own funds, debt is taken on to cover the funds needed to execute the project. This is typically known as debt financing.
Debt Finance: What is Debt Financing?
Debt financing is when one party, the borrower (investment sponsor), borrows funds from another party, the lender (you), with clearly defined terms concerning the timeline of the debt financing, repayment of the funds, and any other associated fees or conditions. Along with these conditions, also known as terms, debt financing may also provide additional security to the lender in the form of collateral or recourse.
What is Collateral?
One of the most common ways to provide security for a lender (you) is through collateral. Simply put, collateral is an item of value that the borrower (investment sponsor) pledges as their “stake in the game”. Lenders will often prefer to work with borrowers (investment sponsors) who are willing and able to pledge strong collateral for their loan. Not only does this reduce the risk as a lender (you), but it can also demonstrate the borrower’s (investment sponsors) commitment to the project. A Loan-to-Value calculation is a common way lenders (you) and others in the industry display the amount of collateral backing a loan. This is a simple calculation, performed by dividing the loan’s principal balance (amount lent to the borrower) by the value that the property will be worth based on the borrower’s (investment sponsors) plans for it. To learn more about the valuation methodologies of one of Preferred Trust’s partners, click here.
What is recourse? A Look at Non-Recourse Debt Financing and Types
Recourse can be broken down into three main subgroups:
- Full recourse debt financing
- Limited recourse debt financing
- Non-recourse debt financing
While recourse can take many forms, it is only relevant in a default scenario. Recourse comes into play once a property has been foreclosed upon and sold to recoup the principal. Should the foreclosure and sale of a property not fully pay off the balance of the debt, recourse will be the next lever a lender (you) can pull. Full recourse is the most optimal scenario. This allows the lender (you) to pursue assets the borrower (investment sponsor) owns to pay off this “deficiency” in a foreclosure event. This is the only form of recourse that allows the lender (you) to pursue the assets of the borrower (investment sponsor) under a normal default scenario. Limited recourse provides fewer benefits to the lender(you) but still provides some security. Typically, limited recourse only will provide the lender (you) the ability to pursue the borrower’s (investment sponsors) assets after a foreclosure and deficiency should they violate any “bad boy carveouts”. These are violated when a borrower (investment sponsor) intentionally devalues a property, which causes the lender (you) to take a larger loss at sale than they otherwise would have. Nonrecourse is just that, no recourse. In this scenario, the lender (you) only has their debt agreement and any potential collateral as security for the debt.
When borrowing within a Self-Directed IRA (SDIRA), it's important to understand that only non-recourse debt financing is allowed. This means that if you default on your obligations, the lender (non-recourse bank) can recover the collateral, typically the asset itself, but cannot pursue the IRA holder’s other personal assets. This protects the tax-advantaged status of the IRA and limits liability strictly to the investment tied to the loan.
Conclusion
Overall, debt financing is an interesting and complicated field. With many participants and moving pieces, it is important to understand all aspects of the process to ensure you can be better informed and engage with the business effectively.
Debt financing is more than just borrowing money, it's a strategic tool that empowers individuals and businesses to fund opportunities, preserve liquidity, and scale projects without sacrificing ownership. By understanding the key elements of debt financing, such as terms, collateral, and types of recourse, you position yourself to make smarter, more informed financial decisions. Whether you’re an investor evaluating lending opportunities or a borrower planning your next venture, grasping the mechanics of debt financing can open doors to stronger, more secure financial outcomes.
