Co-Signing Loans | By Guest Author: Linda Stern, Licensed Insolvency Trustee
Financial planners all agree on one point. Co-signing loans is a gamble for the co-signer mainly because you will carry all the risk and receive no tangible benefit for it. Co-signers make promises to pay loans if the primary applicant defaults. And with it, many take on risks without realizing the full impact of what they really signed up for. Yet this practise remains common in the lending industry.
Why Co-Sign Loans at All?
Mainly, people enter into these transactions for emotional reasons, not financial. Your sense of obligation to help a child or close family member drives the decision. Co-signers that are deemed acceptable by lenders already have an established credit history with excellent credit scores. Therefore, with the risk covered by co-signers, banks are more likely to approve loans for individuals who may otherwise not qualify to receive them. Examples include school loans or a first mortgage for young adults.
Credit scores matter as they influence everyday life. A healthy credit history opens up access to goods and services on credit to make life more comfortable. Examples are monthly cell phone contracts, utility bills and rental apartments. Even certain types of jobs are dependent on the quality of your credit score.
Without doubt, a co-signer can provide a young adult with an invaluable start in life. In addition to obtaining financing, these loans help the individual get started with establishing their own good credit.
If this is indeed your reason for co-signing that loan, then you must look out for, or try to negotiate, a co-signer release clause. This will allow you to remove yourself as a co-signer once the primary applicant has built up their own credit reputation and demonstrated financial trustworthiness. Some lenders include such clauses in student loans. They would release the co-signer after the primary applicant makes regular payments by the due dates for 24 months.
If this option is not available, then you must contend with the risk. Once you sign the documents, you are 100% liable for the debt in the event of a default. The only way to get out of the agreement in the future is for the primary applicant to re-apply and qualify for the loan on his or her own.
Evaluate the Risk
Anyone considering co-signing loans must walk into this arrangement with eyes wide open. Of course, trusting the person you are co-signing with is a big part of this evaluation. However, beyond that, you must fully understand and be prepared for the potential of a loan default.
This risk is especially important to consider if you are approaching retirement. If your own income is about to flatline, ask yourself if will you be able to take this on above your your existing financial commitments?
You must read the fine print to understand the lender’s criteria for triggering a default. How much flexibility does the lender have with the payment terms? Does the loan include a death or disability discharge clause in case the primary borrower suffers a tragic accident?
Examine the Alternatives
Before co-signing that loan, consider all alternatives. In particular, student loans should be the last, and not first option for financing an education. Student loans take a long time to pay off and the burden arrives at a time when other expensive lifestyle choices must be made, like buying a house or starting a family.
If you are co-signing a mortgage loan, then consider buying the house yourself if your circumstances permit this. You can rent it to your child until they have saved for a larger down payment or gained enough credit to buy it from you. This way, at least you own an asset in exchange for the risk.
Many co-signers do not understand the full impact of the agreement they enter into. Some assume they are only responsible for half the loan. In fact, upon default, the lender will come after you for the full outstanding balance. They would actually sue you first, ahead of the primary applicant, because their chances of recovering the funds are greater with you. You have better credit!
Co-signing loans will raise your debt-to-income ratio. The loan will appear on your credit record. This may affect your own qualification for mortgages and auto loans until the debt is paid off.
If the primary applicant stops making payments or is consistently late with them, your credit reputation will take the hit. Creditors will subject you to collection calls and even wage garnishments. And if your bank account is with the same lending institution, they could freeze that asset.
And finally, if you resort to making the payments to save your credit reputation, then your own finances may suffer. You could have trouble making ends meet or have to contend with insufficient retirement savings.
Without doubt, you must absolutely trust the person you are signing the loan with and not take the decision lightly. At the least, reach out for an independent financial opinion about this risk. You might want your financial advisor or accountant to review the agreement before you sign it.
As noted above, co-signing loans is often an emotional decision to help a loved one. Most people do not take into consideration the strain that relationships may be put under if the loan falls into arrears.
Nobody can predict the future. But this is what the worst-case scenario looks like: In the event of a default, missed and late payments will directly affect your credit score. You will have to take on the additional task of monitoring the payments as if they are your own. And the primary applicant might not want your constant queries about why payments are not made.
Sadly, the reality of taking on a financial risk without the benefits hits home only when it is too late. Co-signing loans has been known to destroy family relationships and friendships. If you feel the risk appears too high for you, then it is better to simply say, “No.” You might initially feel guilty about not helping out. But the age-old dictum of living within your means should prevail for both you and your loved one.
If you have already fallen into unmanageable debt because of co-signing a loan, then you must seek out credit counselling right away. The consequences of living with long-term debt problems can be very difficult on your health and wellbeing. A qualified credit counsellor will review your circumstances to recommend one of many solutions available for debt problems.
Linda Stern, a Licensed Insolvency Trustee, is a guest blogger for Family and Credit Counselling Services, a blended not-for profit community-based agency offering debt counselling & management as well as family/individual support services within York region.