It happens to many financially responsible people at some time or another: A friend or family member asks them to co-sign on a car loan, personal loan or even a mortgage loan. Should you do it?
Before you answer that question it’s a good idea to have all of the facts. It’s important to remember that there is a reason why banks are requesting a co-signer. It’s because they feel that there is a high amount of risk involved in taking on the loan — enough risk that the bank doesn’t feel comfortable lending to the signer by themselves.
The fact of the matter is when you co-sign on a loan or mortgage, the bank is basically transferring a good portion of the risk from themselves to you, the person with a proven solid financial history of paying their debts.
Before you co-sign on that loan and take on that risk, it’s important to understand some of the hidden truths about co-signing on a loan.
You credit suffers if late payments are made
As a co-signer, any late payment made on the loan affects not just the credit of the primary borrower, but your credit as well. What’s worse, because all of the loan notices go to the primary borrower’s mailing address, you might not be aware of a late payment until a lot of precious time has gone by.
As such, your credit information may be negatively affected even before you’re aware that you need to do something about it.
If the primary borrower defaults, you are responsible for the loan
Many times people think that the responsibility of the co-signer is minimal. The truth of the matter, however, is that if the primary borrower defaults, you are 100% responsible to pay back that loan – no matter how big it is. Gaining ownership of the asset that secured the loan (provided it’s a secured loan and not an unsecured loan) may not be as easy as you think if the primary borrower is unwilling to leave the house or give you back the car or other item that was counted as loan security.
Your own credit approval chances may be affected
Loan approvals are based in part on a borrower’s debt-to-income ratio (DTI). The debt-to-income ratio is calculated by dividing the monthly total of loan, mortgage and credit card payments on their credit report by the person’s gross monthly income. So, if you had $1,000 in monthly debt payments and $4,000 in monthly gross income, your DTI would be 25%.
Co-signing on a loan for another person means that their loan or mortgage payment will be counted against you when DTI is calculated, which could make getting a loan that you need for yourself more difficult.
Relationships could be strained – or lost
Many familial and friend relationships have been strained or completely destroyed due to borrowed money that was never paid back. Before you agree to co-signing on a loan, consider whether you’re willing to forget about the money if that person leaves you with the burden of paying the loan back. Would you be okay with the possibility of losing your relationship with that person forever should the loan repayment not go as well as you’d hoped? If not, co-signing is a bad idea.
You could face tax consequences in the case of a loan default
If the primary borrower refuses to pay on the loan and you can’t pay the full amount, the lender may consider a debt settlement. A debt settlement means that the lender settles for only a portion of the loan being paid. For instance, if the loan balance is $10,000, the lender in a non-payment situation might settle for $5,000 and call it good. However, they will report the loan to the credit bureau as “settled” which would negatively affect your credit score.
What’s worse is that there may be tax consequences to you for the $5,000 you didn’t pay. You may have to claim the remaining unpaid $5,000 “settled” balance as debt forgiveness income on your tax return.
An exception to the rule?
Truthfully, there are very few situations in which you should consider taking on the risk of co-signing a loan for another person. One possible exception in which people might disagree is in the case of co-signing for a loan for a son or daughter.
However, even in that scenario there are things you need to consider before co-signing on a loan.
- Does your child have a proven history of responsibility? Have they largely been responsible when handling money in the past? Do they pay their bills on time and manage their money well? If so, ask why they haven’t saved enough cash to pay for their purchase and whether or not they regularly contribute to a savings and/or retirement account.
- Does your child make enough money to comfortably cover the payments as well as any insurance premiums, maintenance and repair costs on the item you’re co-signing for? If they are not getting approved for the loan on their own because the bank feels it’s too much debt for their income level, you might consider following suit and telling them you’ll reconsider co-signing for a lesser amount or when they have more income.
- Are you prepared to forget about the money if things go wrong? Or to risk losing your relationship with your child? These are things that need to be discussed before co-signing so that there’s no misunderstandings about expectations on either person’s part.
- Does the child truly need the item they want you to co-sign on? Do they need a car or are there other options, such as public transportation or carpooling that could work until your son or daughter saves enough money to buy a quality used car for cash? Do they need to own a house now or could they rent until they save more cash for a down payment?
The bottom line is that co-signing on a loan should be avoided in most every situation. If you do choose to co-sign on a loan for someone, it’s important to be financially and emotionally prepared for every potential outcome.
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