To Cosign or Not - Learn The Facts Before You Sign
In the world of personal finance, there are two behaviors that are roundly deemed to be foolish: buying lottery tickets and cosigning for a loan. Of the two, the lottery ticket purchase is relatively benign; it is a small waste of money that over time adds up, but has no further negative consequences. Cosigning for a loan, however, can result a number of negative consequences to the cosigner and these consequences need to be taken into consideration before agreeing to cosign for a loan, no matter how close the cosigner is to the borrower.
Was it Mentioned in The Bible?
Credit co-signing is a centuries-old practice whereby a person or persons signs for (or agrees to stand good for) another’s debt. Solomon wrote about the co-signer in the Book of Proverbs in the Bible.
Proverbs 22:26-27 (KJV)
26: Be not thou one of them that strike hands, or of them that are sureties for debts.
27: If thou hast nothing to pay, why should he take away thy bed from under thee?
This was sound advice then and still rings true today. A person usually needs a cosigner because his or her credit is not good enough to guarantee the repayment of the loan. The co-signer is saying, “If he or she doesn't pay back the loan I will.” By signing the loan the co-signer then becomes legally obligated to repay the debt if the person they are vouching for decides to stop paying. If the co-signer fails to repay the loan, then the property could be repossessed and resold to pay off the loan. The original borrower and the co-signer could then face legal action, such as court appointed judgments, wage garnishments, as well as negative remarks on each of their credit records.
Overview and Discussion
There are generally two reasons that a borrower might need a cosigner.
- The borrower has no credit history
- The borrower has bad credit
In both situations, lenders want some assurance that there is a reasonable chance that a loan will be repaid; borrowers who habitually default on loans or whose income is so low that the loan payments will take a large percentage of their take-home pay are very high risk. The cosigner minimizes the risk to the lender in this case. A cosigner, then, is actually lending his or her good name, income and asset base to the borrower. This in itself should be a red flag to anyone asked to cosign for a loan.
Cosignatories take on the obligation to repay loan balances, interest and any penalties that the borrower incurs during the course of the loan if the borrower defaults on the loan. In other words, if the borrower exhibits bad behavior, the person who pays the price for it is the co-signer. In the event the borrower declares Chapter 7 bankruptcy, the debt automatically falls to the cosigner rather than being discharged as it normally would be. Depending on the size of the loan, this may force the cosigner into bankruptcy as well.
The primary recourse that a cosigner has when the borrower defaults on a loan is to sue the borrower for the cosigner's financial damage. Of course, the probability of collecting from the borrower after he or she has already defaulted on a loan is negligible. If the borrower has a steady income, the court may call for wage garnishment, but if the default was caused by a job loss, divorce or other life change, then a win still may not result in financial recovery. Unfortunately, there is no way to reclaim the damage done to a cosigner's credit other than exercising the same discipline and conscientiousness that created the great credit rating.
Are there circumstances in which cosigning a loan makes sense? One common situation is that of a teen purchasing a car. If the borrower is a minor and it is understood that the adult cosigner (in this case, a parent or guardian) can and will take ownership of the asset being purchased if the minor fails to make payments, then cosigning for the loan is reasonable. The act of taking out a loan and making payments becomes a learning tool, and having a parent monitor the child's loan repayment ensures that the loan is repaid. This is a double win for the child, because the teen not only acquires the car but he or she also begins adult life with a good credit rating. A second situation in which cosigning a loan is sensible is when a small business owner takes personal responsibility for money his or her business borrows. This is risky and defies the purpose of forming an LLC or subchapter S corporation, both of which protect personal assets from risk in the event of business failures, but it may be the least costly way to finance business growth. Outside of these two situations, cosigning for a loan is almost always a sure-fire method of losing money, destroying a good credit rating and severing a relationship.
So, how does a person deal with a close friend or family member who asks him or her to cosign? First, establish whether the person is a bad risk or just in a bad place in life before making a decision. If the borrower is a drug addict, alcoholic, compulsive gambler or compulsive shopper, or has just shown a complete lack of responsibility with regard to financial obligations, then he or she should never have access to money, period. If the person has been responsible in the past but has had some reversals in life and needs a hand up, then there are three options that minimize risk to the relationship and to the potential cosigner's finances. The first is just to give the borrower the money as a gift. It's easier to become a blessing than it is to be a watchdog. The second is to refer the borrower to an alternate means of borrowing. Peer-to-peer lending resources, for example, willingly take borrowers with shaky credit and allow individual lenders to pool resources and fund the loan. Because individual lenders who participate limit risk to $50.00 or so, there is a strong likelihood of the loan being approved and fully funded in a short time. The interest rate charged will be higher than that of a bank, but it may be right in line with those offered by finance companies and will be significantly less than that charged by credit card companies or payday lenders. Using a peer-to-peer lender also allows the borrower to rebuild his or her credit, as timely payment is communicated to credit bureaus. The third option, if the potential cosigner has the cash and is willing to put it at risk, is to become the lender. There are several online resources that offer templates for promissory notes, repayment agreements, loan security agreements and demand notices that allow a layman to craft a solid, specific arrangement to lend money to another individual. These documents will stand up in court if they are completed correctly, and this gives the lender more control over the situation in the event of a default than he or she would have as a loan cosigner. The bottom line is that if a person can't afford to lose money, either through gifting or lending, then he or she should definitely say "no" to cosigning for a loan.
Things To Consider Before Co-Signing
A person usually co-signs for a family member or a friend, so if something goes wrong and the person whom they co-signed for can’t repay the loan. It could cause bitterness and animosity between the two people thus causing further problems among the entire family or circle of friends. The person making the loan may have every intention of repaying it; however, sometimes bad things happen to good people. Before agreeing to co-sign ask yourself these questions,
- If he or she fails to repay the loan will I be able to repay the debt without putting myself in a financial bind.
- Is the person whom you are signing for financially stable enough to make the payments on this loan to pay off the debt?
- What happens if they move away, become ill, or die? (It would be a good idea to insure the loan against job loss, sickness, and death.
It is a big responsibility to cosign for anyone, if you choose to do it, make sure you have all the facts and are fully aware of what you are getting into.
Rare and Exceptional Benefits of Co-Signing
There are some instances in which it would be beneficial to co-sign,
- A child or sibling who is just starting out and needs a hand up.
- A friend or family member that is recovering from an illness or extreme financial hardship.
- An elderly parent, family member, or friend who has a genuine need but cannot get the loan due to his or her age.
Credit is hard to obtain in today’s society, especially after the economic meltdown and the bank bailouts. So for a young person who is just starting out, getting the credit that he or she needs could be a virtual impossibility. That is where a Co-signer could be just what that person needs to establish his or her credit worthiness.
Unpaid medical bills are the number-one reason for bankruptcy in the 21st Century. An unexpected illness or the death of a spouse could be financially devastating to a person or family. A co-signer could make the difference in that person or family's financial recovery.
Banks, credit institutions, some nursing homes and assisted-living communities, are hesitant to give credit to seniors after they reach a certain age. A co-signer may be the difference to that person or person(s) continued independent living. Here are the facts; now it is your choice to sign or not to sign.