Understanding the Risks of Co-Signing a Loan
One approach to assist a friend or member of the family who would not otherwise be eligible for a loan or a reduced interest rate is to co-sign the loan. For instance, using your good credit to assist your adult daughter in acquiring a mortgage for her first home, or to provide a helping hand to your best friend who has been having problems getting a credit card, may seem a helpful, low-risk, and kind gesture. However, the repercussions can be far-reaching.
So, before signing on the dotted line, understand the risks involved and if there are any alternative options to co-signing the loan.
1. You Are Liable For The Loan If The Primary Borrower Defaults.
The biggest risk of co-signing a loan is that you not only lend your good credit reputation to help someone else but also promise to pay the debt if the primary borrower defaults. It will include late fees or collection costs too. Therefore, before you co-sign a loan, you must assess your finances and ensure you can make the payments if the primary borrower misses a payment or stops paying altogether.
If the primary borrower took out a secured loan, you might be entitled to take possession of the asset used to finance the loan. However, if the borrower refuses to vacate the property, give you back the vehicle, or return any other security used to get the loan it will not be a simple task.
2. Your Credit Scores Can Take A Hit
If your primary borrower misses a single loan payment deadline or payments are made in a spotty fashion your credit scores can drop. It will be challenging for you to qualify for a mortgage or obtain a loan with a low-interest rate in the future.
When you co-sign a loan, you should take a free look at your credit score to be aware of what is going on, as payment history accounts for 35% of a borrower’s FICO score and can stay on your credit report for up to 7 years.
3. Your Borrowing Power May Be Affected
When approving a loan, lenders look to your debt-to-income ratio (DTI). It is the percentage of your available credit. For instance, if your gross monthly income is $4000 and monthly debt payments are $1000, your DTI will be 25%.
When you co-sign a loan, that amount will be counted against you when your Debt-to-income ratio is calculated. So, depending on the amount of debt you have securing a mortgage or any other type of loan will be more difficult.
4. It Might Have Tax Repercussions.
The lender can be open to a debt settlement if the principal borrower defaults on the loan and you cannot make the full payment. In a debt settlement, the lender agrees to accept only a portion of the loan as payment. For instance, if there is a $10,000 loan debt, the lender in a non-payment situation might accept $5,000 and consider the matter resolved. However, the lenders will mark the loan as “settled” with the credit agency. It will lower your credit score.
Even worse, the $5,000 you did not pay may have tax repercussions for you. The $5,000 “settled” balance that is still outstanding may require you to report it as income on your tax return.
5. It Can Sour Your Relationship With The Borrower
“Nothing separates family or friends like borrowed money”. So, the last, and maybe most significant, justification for staying away from co-signing a loan is that it can strain friendship and family ties. It might lead to friction and even animosity, for example, if the primary borrower did not reveal missed payments and your finances suddenly suffered. Also, often the emotional pain is worse than the financial loss.
How Can You Help And Still Safeguard Your Financial Situation?
If you believe that the hazards of co-signing are too risky, there are other ways to support a family member or friend in need without jeopardizing your financial stability. Take into account these options.
Consider A Family Loan:
If the borrower wants a family member to co-sign, they might choose this option instead. This loan is between family members, but the lender and you will select how it will be structured. There is no formal application or approval process, but there should be a written agreement between the two parties outlining the terms notarized. Family loans can assist borrowers in obtaining more affordable loans and avoiding predatory lenders.
Look For Financing Elsewhere
Finding a loan can be difficult, particularly for someone with a bad credit score. If your friend or family member needs a co-signer to qualify for a loan, they may need help looking for a lender with less rigorous lending requirements. Search for online personal loan options from lending platforms that may have less severe qualifying conditions. Then, use the prequalification procedure to find options available without a co-signer. If the borrower qualifies for a loan, you may not need to be a co-signer.
And if your son needs a co-signer for a School or auto loan, you could help by directing him towards grants and scholarships or other low-credit lending options he may be eligible for.
Lend The Money Yourself
Another choice is to give someone you care about the money he needs. It can just be a gift to assist them meet the requirements for the loan with a better down payment. The borrower will not have to worry about meeting the requirements for loan approval or the dire financial repercussions of defaulting. You also face much less risk, including less damage to your credit, less legal culpability, and less money at stake. You can also add some strings as you see fit.
Are You Still Willing To Take The Risk?
An important choice that could eventually impact your finances is co-signing a loan. Therefore, you must exercise extreme caution before entering into that kind of financial commitment. Even though there are several reasons why you should not co-sign for a loan, you may still want to do it for someone you trust. However, ensure you gather copies of all the necessary loan-related paperwork and repayment schedule. Also, request the lender to contact you as soon as possible if the borrower misses or is late with a payment. Further, if feasible, keep your liabilities to the amount charged to avoid being responsible for late fees and legal expenses.
If the borrower defaults, these agreements can shield you from having to shoulder the entire financial responsibility.