There could be multiple reasons for an individual to consider co-signing a loan, such as a student loan to fund their child’s education or to help out a family member or friend. If you co-sign a loan for a friend or relative, they may be able to obtain urgent cash or secure funding for whatever they need. However, you will be at serious risk if your co-signee fails to keep up their end of the deal, harming your credit and your relationship with the borrower. Therefore, knowing what you are about to commit to before signing on it is crucial.
What Is Co-Signing a Loan?
A co-signer acts as an additional form of security to lenders. It is a promise given to the lender by the co-signer that the loan will be repaid. A primary borrower’s poor credit history or large debt load may prevent them from obtaining a loan independently. In such cases, a co-signer can be helpful. Generally, the co-signer must have a better credit history than the borrower and a smaller debt-to-income ratio.
With a co-signer’s help, potential borrowers could obtain a loan at a significantly lesser interest rate than they otherwise could. The two leading credit score analysts, FICO and VantageScore, consider a credit score of 670 or greater to be good. This is the score that a co-signer would ideally have, along with a debt-to-income ratio for a mortgage under 43%.
Factors to Take into Account Before Co-signing
You run a significant risk when you co-sign a loan. No matter your financial condition, you are ultimately accountable for the loan if the borrower defaults on the repayments. The following are some considerations before you decide to co-sign for a loan.
Engage In Discussion
Before co-signing, you should discuss the terms with the lender and borrower to fully comprehend the responsibilities of both parties and the consequences if the borrower defaults on the loan. The co-signer should also learn the rights they hold under the laws of the state where the loan was given.
Go Through the Paperwork
Read the paperwork thoroughly to be aware of all loan-related documents, including the terms regarding the co-signer release. In case of disagreements between you and the borrower, you must have the records to handle such situations.
Have A Strategy in Place
You must decide how to deal with the borrower about the loan. For example, you could request access to the online account and stipulate that the borrower should inform you beforehand if the property will be sold or the loan will be refinanced. Additionally, the borrower should inform you if payments may have been missed.
Benefits of Co-signing
Helping Someone in Need
The most satisfying feature of co-signing is helping a friend or a family member get the financial help they need. Whether they are going through a financially challenging time or achieving a significant milestone such as purchasing a house for the first time. For instance, you could co-sign a mortgage loan for a child who is financially responsible but has not got the opportunity to establish a long credit history so they can take advantage of low-interest rates.
Give Someone a Chance
A co-signed loan can be highly beneficial to the borrower. It gives a borrower with little to no credit history, one dealing with increasing debt issues, or even bankruptcy, a chance to make timely payments and get an improved credit score. Since payment history has a significant positive effect on how FICO and VantageScore analyze credit scores, this is exceptionally advantageous.
Drawbacks of Co-signing
Restricted Credit Range
A new loan on your credit report, especially something as big as a mortgage, could elevate your debt-to-income ratio to the extent that you cannot obtain a different sizable loan.
Obtaining Credit Problems
There will be negative influences on your credit reports, ratings, and collection efforts, in case of late payments, missing certain payments, or bankruptcy. Dealing with a collection agency could lead to penalties and the risk of tarnishing your earnings.
The lender will inform the credit agencies of the missed payments or loan default if the borrower stops repaying the loan and you refuse to pick it up. Consequently, your previously excellent scores can be badly affected if such data lands on your credit records.
You Are in A Risky Position Legally
In case of the borrower’s demise, bankruptcy, defaults, or if the lender files an action in court to obtain the payment, you will be obliged to repay the loan. Moreover, the lender could approach you for payment before approaching the borrower.
Since you hold equal legal responsibility for the loan, the lender can sue you if you fail to repay the loan. Consequently, a judge could order you to pay the total loan immediately, along with the court costs. In addition, recovering any of that money could require you to sue your friend.
May Cause Relationship Problems
Problematic financial discussions could complicate relationships. Particularly if the borrower chooses not to repay the loan, leaving you in a tough spot.
Solutions If the Borrower Defaults
Stall: If the borrower wants to pay but is currently incapable of doing so, and your finances aren’t strong enough to take over the payments, you can request a forbearance from the lender.
Find a loan to pay the co-signed loan: Richard Lee, a partner at the Los Angeles law firm Salisian Lee, directs that you or the borrower could find a third party, any company or lender, prepared to finance the co-signed loan and take an assignment of the principal debt.
Refinance: Sue Katz, a personal financial counselor and community outreach coordinator with American Consumer Credit Counselling, states that if the loan is through a bank with which the signer or co-signer has a history, then there is a possibility that the bank might renegotiate the terms of the loan.
Refinance Independently: Avoid involving the borrower and take complete control of the loan. This could be a fair approach to obtain lower monthly payments with a lower interest rate. Here, your co-borrower can send payments to you rather than the lender.
Bankruptcy: While getting a student loan discharged in bankruptcy is tough, this might be your only way to proceed if you have additional co-signed loans.
Undoubtedly, co-signing a loan is risky, both financially and personally. Nevertheless, refusing to a loved one in need can be awful. Still, explain your decision with affection and respect if you choose to refrain from co-signing a loan. Ensure you explain to them the responsibilities you would be taking on by co-signing a loan, as many individuals need to be made aware of the risks they expect you to take with your own money. However, if you decide to co-sign, ensure you are familiar with the overall process.