It might feel like the right thing to do if your child or a close family member asks you to co-sign their debt. You probably feel obligated because without you they wouldn’t be able to get the loan. But is it worth it and is it safe?
Here’s what you must know about co-signing debts.
What Does Co-signing a Loan Mean?
When you co-sign a loan, you promise to pay the loan if the primary borrower can’t. It’s almost like a guarantee for the lender. It’s less risky for them to lend money to the borrower if they know there is someone else that can pay the loan if the borrower defaults.
Keep in mind, this means that you could be responsible for the loan. While you aren’t primarily responsible for payments, if the borrower stops making them, the lender comes after you next.
Who Needs a Co-signer?
Not everyone needs a co-signer. Typically, borrowers that need someone to sign on the loan with them have bad credit, low income, or a poor or no payment history. In other words, they are too high risk for the lender to approve them on their own.
A co-signer adds another person responsible for the loan. But to be a good co–signer, you’ll need good credit, a low debt ratio, and stable income. Lenders evaluate all of this information about you to determine if you make the loan less risky.
What Happens if the Borrower Doesn’t Pay?
Here’s where the problems begin. If the borrower misses payments, one of two things can happen.
- The lender can come to you asking for the monthly payment or for you to make up what the borrower didn’t pay
- If the loan has an acceleration clause, the lender can request the entire remaining amount of the loan from you
How to Decide if you Should Co-sign a Loan
Deciding whether you should co-sign a loan is a personal decision, but here are some questions to ask yourself to decide if it’s right.
- Why does the borrower need a co-signer? Does he/she have bad credit or is he/she just starting out and doesn’t have enough credit to qualify?
- Do you have an agreement between the two of you about what will happen if he/she cannot make the payments? This should include communication requirements if the borrower is having trouble and how you’ll handle the payments if that happens.
- Can you handle the payments if the borrower defaults? Look at the monthly payment and how it fits into your budget as well as the total loan amount if the loan has an acceleration clause.
Does Co-signing a Loan Affect Your Credit?
If you co-sign on a loan, the lender pulls your credit and reports the loan to the credit bureaus. This means the borrower’s payment patterns affect your credit score. If the borrower pays on time, it can help your credit score. If the borrower misses payments, though, it can drastically hurt your credit score.
If it gets any further, such as a chargeoff or sent to collections, it can damage your credit score even further.
Ways to Protect Yourself as a Co-signer
If you decide you are going to co-sign on a loan, you should take some necessary precautions to protect yourself in addition to considering the questions above.
- Ask the lender to give you status updates, especially if the borrower falls behind. It’s best if you can get the updates in writing, too.
- Get a loan release when the loan is paid off so that you have proof it was paid off in case it doesn’t get reported correctly on the credit report. This could be something as simple as a letter from the lender stating the loan was paid in full and you are released from it.
What About Co-signing a Mortgage?
While you could co-sign personal loans or auto loans, the most common loans borrowers need help with is the mortgage.
This is also the riskiest loan for you to co-sign, so it’s important to know your rights.
- You don’t own the property or have rights to it. You are just the ‘guarantee’ for payment should the borrower not be able to pay it.
- You aren’t responsible for the payments unless the borrower can’t pay them. If you find out after the fact, though, you’ll also have to pay the late fees and accrued interest.
- If there’s an acceleration clause, you could be entirely responsible for the rest of the mortgage (which can be large).
Can you Remove Yourself as a Co-signer?
Some lenders might allow a co-signer release, but it depends on the circumstances. You can’t just remove yourself from the loan. You must ask the borrower and the lender for approval. The borrower must sign a release, and the lender must be able to believe beyond a reasonable doubt that the borrower can afford the payments since they are giving up their ‘backup’ or guarantee in you.
It’s a big decision to be a co-signer and it’s not right for everyone. As much as you want to help your child or other family member, there are risks, especially if the borrower defaults.
Financially, you could be on the hook for the loan, which can be detrimental to your finances. It could also hurt your credit score, all for trying to help someone. Socially, it could hurt your relationship with your loved one if they default or don’t take the loan seriously.
Our biggest suggestion is to have a written agreement with your loved one regarding how they will handle the account and what they’ll do in the case of the unexpected. If you find yourself on a co-signed loan that you are now on the hook for and can’t afford, let the credit counsellors at EmpireOne Credit help you today. We’ll help you explore your options and determine the best choice to help you get your finances back on track.