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The basics of co-signing a loan

Lenders generally take a cautious approach to first-time borrowers. Without a credit history to go on, it's not unusual for them to require a co-signer before they hand over a check.

A borrower who's been told he needs a co-signer isn't necessarily considered a poor credit risk. Often, it's because there isn't enough information to make an informed decision, which in banking circles means 'No.'

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Jack Naramore, president and CEO of the Birmingham, Ala., region of Colonial Bank, estimates that only about 10 percent of borrowers need a co-signer to qualify for a loan. Most often, the reason is that a person has little or no credit history upon which to base a decision.

Lending help
The most frequent scenario is a parent "trying to help out a child or a college student," he says.

Co-signers typically will have well-established credit to help the borrower qualify for the loan. But being a co-signer isn't like giving a person a reference on a job application. It carries a weighty responsibility and some potentially significant implications that need to be understood before it's taken on.

That's because you're not just vouching for the borrower's ability to repay the debt, you're promising to pay it yourself if the borrower defaults.

Most people would probably say, "That's fine. My (insert relative or friend) since third grade has a good job, is very responsible and will make every single payment."

And that may be absolutely true. It's also true that unanticipated things happen. People lose their jobs, they get sick and they die unexpectedly. If, for whatever reason, the borrower doesn't make the payments, you're on the hook.

Careful, co-signer
If someone asks you to be a co-signer on a loan, you need to consider the borrower's character and ability to make the payments, and whether you could afford the debt if the borrower defaults, Naramore says.

"The main thing they need to understand is that they are signing that loan for a reason," Naramore says. "If the loan goes bad, they have to pay it back. That's what everybody has to be prepared for. They need to look at this as if they were taking out the loan themselves."

You should be especially wary if the borrower asking you to co-sign is getting the loan from a finance company. That means he's been rejected by traditional lenders and the loan carries a high interest rate. Plus, the Federal Trade Commission reports that three out of four co-signed loans with finance companies wind up being paid by the co-signer

The FTC puts the situation into simple terms in its information on co-signing. You're being asked to take a risk that a professional lender has decided not to take.

The risks are real and significant. The lender doesn't have to exhaust every possible means to get the money from the borrower before he comes after you.

"The bank or creditor can select which debtor he wants to pursue," says Bob Doyle, a certified public accountant and personal financial specialist in St. Petersburg, Fla. "He'll pick the one who is the most likely to pay the quickest."

If the lender sues to collect, you could get hit with attorneys' fees, and if he wins the suit, your wages could be garnished. If you pledged property, such as your car or furniture, you could lose it.

If you're thinking that a lender could just repossess the item, think what that will do to your credit report. Plus, if it's a car, it's been depreciating since the day it was driven off the lot. It might not be worth as much as the balance of the loan.

In addition, most people don't realize that the loan can affect their own ability to get financing. Since a co-signer is legally obligated to pay the debt if the borrower defaults, it counts the same as their own loans on a credit report and is factored into their debt-to-earnings ratio.

"If you're one of those folks out there who may not have exemplary credit and in two years realize you need to get a car and you have mortgage and credit card balances, I don't think you'd qualify," Doyle says. "That's your risk."

Stuart Cohen sees what can happen with co-signed loans quite often. He's the regional education coordinator for the Consumer Credit Counseling Service of Southern New England.

"There are people who end up with debts they didn't know they were going to have," Cohen says. "They still have to repay them, often by using our debt-repayment plan. I can't tell you how many family relationships are stressed by that."

Minimizing the risk
The FTC suggests two steps you can take to try to protect yourself.

First, ask the lender to put in writing that he will notify you if the borrower doesn't make a payment. That should give you time to handle the situation before it gets out of control.

Second, ask if you can limit your responsibility to the value of the loan itself, and not late charges or other collection fees.

If you do need to free up some of your credit line after you've cosigned on a loan, it's possible to get your name taken off the note, Naramore says.

"If you're three years into a five-year loan and the borrower has made every payment and now has a very nice income, that's something we could do," he says.

On a mortgage, it may require refinancing the loan, but if it takes tens of thousands of dollars of potential debt off your credit report when you're shopping for a mortgage of your own, it's worth the effort.

For all the cautionary information, the experts say co-signing can be very helpful in the right circumstances. Family members helped both Doyle and Cohen by co-signing for loans when they were just getting started. It's not that uncommon, and it can be a great way to help a person establish credit.

"I had a job and great salary opportunities, but no one was going to loan a kid money to buy a used car," Doyle says. "I paid it off in 18 months. Boom, it was done. I had established credit. Then people wanted to throw money at me."

If you're the person who's been told you need a co-signer, Cohen suggests putting off a purchase until you can save more or buying something less expensive.

"Or, perhaps if you go to the bank, they might consider giving you a loan for a smaller amount, using nontraditional means of credit, such as showing them you have on-time utility or rental payments. Then you might not need a co-signer You also could do a passbook savings loan or a secured savings loan. That allows you as a consumer to give them $1,000, they give you back $1,000, and you pay it off with interest. Then no one is put into harm's way."

The bottom line, Cohen says, is that you need to think carefully before taking out a loan that requires a co-signer

"If you go to a reputable lender with market-rate interest rates and you feel desperate, it's probably a signal you shouldn't be getting this loan," he says. "That will take you into finance companies that charge higher interest rates.

"People with poor credit will go to finance companies and have to get a co-signer We see that all the time. There's nothing worse than being locked into a $12,000 balance on a $5,000 car."

 
-- Posted: Sept. 27, 2002
   

 

 
 

 

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