There are many reasons to consider co-signing a loan. Your children may need your signature to take out student loans to pay for college. Maybe your parents need money and have asked you to co-sign. You might have a lifelong friend who has fallen on hard times and could use your good credit to help them get back on their feet.
None of this, of course, not even your parents playing the we-gave-birth-to-you card, necessarily means that you should co-sign a loan. It’s understandable if you’re thinking about it. Before signing on the dotted line, take a quick tutorial on what you’re about to get yourself into first.
Considerations Before Co-Signing
Arguments for Co-Signing a Loan
A co-signer can be a lifeline for a borrower with a bad credit score or no credit history at all. Co-signers with excellent credit can help someone to get a loan with a decent interest rate, instead of one with an extremely high interest rate and restrictive terms.
Both the borrower and co-signer can see their credit scores rise if the borrower makes the loan payments on time each month. The borrower with bad credit may find this far more meaningful, as it might allow him or her to refinance the loan without the co-signer or to take on new debt without a co-signer.
Recent college graduates with lots of student debt may find it advantageous to have a co-signer. A co-signer could save the recent graduate thousands of dollars in interest over the life of the loan — while assisting the new grad in building a solid FICO score and other credit history benchmarks. The same goes with those who are struggling to take out an auto loan. The borrower’s debt-to-income ratio may make her or him ineligible for automaker-subsidized below-market-rate or 0% financing deals. A co-signer can help the borrower qualify for the special car incentives.
It can be a brutal world out there, and you want to help someone you care about. That’s a perfectly reasonable argument, and it isn’t as if there aren’t positive stories of co-signing a loan. There are.
“I have co-signed on two car loans, one for each of my kids. I have also given a loan on a credit card — a cash advance — to each of my kids: one for $22,000 and one for $4,300,” says Jan Carter, a former information technology professional from Nevada and author of “Shifting to the Business of Life: A Survival Guide for Young Adults.”
For Carter, everything worked out. It may have even helped her own credit. At least, she says, she was able to take out a personal loan for solar panel installation and to buy her own car while having co-signed loans.
“So it’s all been good. I’m very fortunate to have good experiences in the world of co-signing,” Carter says.
Arguments Against Co-Signing a Loan
The main downside is that if the borrower has trouble paying off the loan, that trouble becomes your own.
“When a person needs a co-signer, it is because the institution does not believe that the person has the ability to pay it back,” says Debbi King, author of three books on personal finance and life coach in the greater Philadelphia area.
“When you co-sign for them,” she adds, “you are risking your financial reputation and your relationship. Any payment that is late or missed will affect your credit score and theirs. And every time that you see this person, you will be questioning every money decision they make wondering how it will affect your loan.”
It’s easy to think in vague terms that, yes, if your co-signer can’t pay, it’ll be stressful for a little while, but human beings are an optimistic bunch. So if you figure you can take a hit to your credit score, remember: You could be in for more than a hit. You might take a beating.
Denise Winston, the California-based author of “It’s Your Money: Avoid Costly Mistakes,” who was a banker for 25 years, says the following will happen if the person you’re co-signing for can’t pay for the loan:
— You will be asked to make the payments.
— That person’s credit mistakes become your own.
— Future loans could be affected.
And your beating may actually last a few months or even years.
Yael Ishakis, vice president at FM Home Loans in New York, says a client of hers co-signed a mortgage for his nephew.
“Two years later, the nephew was diagnosed with a terrible disease and is no longer able to work,” Ishakis says. “The uncle couldn’t exactly kick his nephew and family out in the streets, and he has been paying their mortgage for them for the past 15 years. This is the kind of responsibility the banks expect of a co-signer.”
Another reason to be at least be a little pessimistic: You may be thinking you’ll just co-sign until your son or daughter or friend sees his or her credit improve and can refinance the loan or have you released as the co-signer. However, the Consumer Financial Protection Bureau issued a report in 2015 that found 90% of private student loan borrowers who applied to have their co-signer released from the loan were turned down. So if you’re co-signing a private student loan, for instance, you have a 90% chance that — at least initially — you’ll be attached to this loan for the long haul.
[READ: How to Remove Yourself as a Co-Signer on a Loan]
What Happens if the Borrower Defaults?
So what happens if you’ve tried to help a loved one, and that loved one can’t keep up with the payments, so you’re stuck paying for his or her credit cards, student loans, car or even house? Or perhaps you also can’t pay, and you’re watching your once-sparkling credit score crash and burn. Maybe the situation is even worse, and your family member or friend won’t make the payments. What then? Are you stuck paying off the loan, or is there an exit plan?
The answer to both parts of the question is yes. Neither situation is pretty, but if your goal is to simply extract yourself from the predicament, here are some of your options.
— Stall. If the original person doing the borrowing is willing to pay but can’t right now, and you can’t even temporarily take over the payments, you can always see whether the lender will put a forbearance in place. This is essentially a temporary reprieve, usually for just a month or two, although with student loans, the time can be more generous, like six to 12 months.
— Take out a loan to pay off the co-signed loan. As Richard Lee, a partner at the Los Angeles-based law firm Salisian Lee, suggests, you or the borrower might find a third party, “like a debt-consolidation company or some other hard-money private lender, willing to take a risk by financing the early payoff of the original loan and taking an assignment of the principal debt.”
The idea is that this third party pays off the debt, and the borrower — that is, your adult child or relative — is responsible for the new loan, Lee says. The odds of finding a lender who will do this are not good, but if you can swing it, your problems are over.
— Refinance. “This can sometimes be a long shot, but if the loan is through a bank that the signer or co-signer have worked with in the past and there is history, it’s possible the bank will be willing to renegotiate the terms of the loan,” says Sue Katz, a personal financial counselor and community outreach coordinator with American Consumer Credit Counseling, a nonprofit based in Auburndale, Massachusetts.
Even if you and your borrower can refinance for a smaller monthly payment, the borrower may wind up paying more in interest if the loan is stretched further into the future, from, say, a three-year loan into a five-year loan.
“Once your co-signer has reverted to late payments or defaulted altogether, it has been my experience that your best way out is not to try and renegotiate the loan to smaller payments,” says Kristen Fricks-Roman, a senior vice president and financial advisor with Morgan Stanley in Atlanta.
— Refinance on your own. Take full ownership of the loan and don’t have the borrower on board. If the goal is to simply get lower monthly payments with a smaller interest rate so your borrower can pay off the loan more easily, sending payments to you instead of the lender, this might be a reasonable plan.
Still, there is plenty to consider. You thought the consequences of co-signing were bad? If you refinance the entire debt on your own — that house your son was buying, the credit card debt your nephew collected — that’s all yours now. And while the plan may be to have your co-signer pay you back, you could be left high and dry with the debt.
On the other hand, as the sole owner, you’d have leverage to insist your tenant continue to make mortgage payments, which would be smaller and more manageable, or that he or she pay rent to you.
— Recoup your money another way. If this debt you’ve co-signed for has truly drained your bank account and you want to make your money back, Fricks-Roman has some interesting ideas.
First, with any luck, your relative or friend wants to pay you back and feels terrible about this loan gone awry. If that’s the case, you could ask the borrower to direct-deposit part of his or her paycheck into your account, Fricks-Roman suggests.
But if that isn’t going to happen, Fricks-Roman says less-appealing options include redoing your will and excluding the loan amount from it. That won’t work for everyone, especially if you’re worried about your own retirement, let alone leaving something behind in a will.
— Bankruptcy. It can be difficult to get student loans discharged in a bankruptcy, but with other co-signed loans, this might be the way you’ll have to go.
But there’s another, more hopeful thought, Lee points out. “Even if the parents don’t want to declare bankruptcy for any of the chapters — Chapter 7, Chapter 11, Chapter 13 — it can be a useful negotiation threat to gain leverage with the original lender in renegotiating a forbearance or other type of grace period to allow the child to get back on his feet, get a job and restart making payments,” Lee says.
[READ: Should You Co-Sign a Mortgage Loan?]
How Can You Protect Your Credit When You Co-Sign a Loan?
In order for co-signers to protect their credit score, it’s important to have a conversation with the primary borrower. There should be communication between the co-signer and borrower about the expectations for each person in order to avoid any differences or issues that should arise.
The co-signer should also have access to her or his credit score and the loan amount in order to keep an eye on payments and make sure the borrower is making on-time payments and in full. In addition, there should be open communication between the two people when a payment is going to be late, so this can help both stay on top of any problems.
The lender should also advise the co-signer about rights and responsibilities.
What Rights Does a Co-Signer Have?
Before you co-sign a loan, review your rights.
No access to the assets attached to loan. Co-signers are not entitled to the loan amount or to the collateral attached to the loan. For example, when you co-sign on a personal loan, you legally cannot receive access to the money.
May be removed from loan. Borrowers can remove the co-signer from the loan without refinancing it into a new loan by going through a co-signer release. The time frame will vary depending on the lender, but many lenders offer co-signer releases after a specific number of consecutive on-time payments. If you’re interested in being released from the loan, read the loan contract, review the requirements and then reach out to the primary borrower, who is the only person who can request a co-signer release.
Can face collections. If the primary borrower defaults, you are legally responsible for the debt obligation, according to what you agreed to when you co-signed the loan. Because of this, you may face collections for the unpaid amount before the borrower, according to the Federal Trade Commission.
Alternatives to Co-Signing a Loan
If you don’t want to co-sign a loan, there are other options you can suggest to the borrower:
— Family loans. The borrower could go for a family loan if the borrower wanted someone within the family to co-sign. This type of loan doesn’t involve third-party lenders, so you won’t need to go through an approval process or complete an application. However, everything within this agreement should be in writing, summarizing the terms between the two parties.
— Apply for bad credit or secured loans. Getting approved for a loan designed for bad credit or secured by collateral, such as a car, home or bank account, may be easier than finding a co-signer.
— Work on your credit. Improving your credit by avoiding late payments and paying down debt can help you get approved for a personal loan without a co-signer.
— Consider loans from alternative lenders. Credit unions, online lenders and other alternatives to big banks might be willing to lend to you even if your credit isn’t ideal.
More from U.S. News
How to Get a Personal Loan With a Co-Signer
What Are the Easiest Loans to Get?
The Pros and Cons of Personal Loans
Should You Co-Sign on a Loan? originally appeared on usnews.com
Update 03/29/23:
