If you’re considering helping your teen or twentysomething child get a loan by co-signing with him or her, be careful. It may be riskier to you than you think. The same holds if you’re contemplating co-signing with another family member.
When you add your signature to the loan documentation, you are taking a risk that the lender is not willing to take; co-signers are only required when the primary borrower isn’t able to qualify alone.
So as much as you may love your child or other relative, ask yourself why he or she would be unable to get approved. Banks usually reject people because they have a history of missing payments or lack sufficient income to afford the loan.
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When Co-Signers Must Pay
And the data shows that lenders have a right to be cautious. According to the Federal Trade Commission, three out of four co-signers end up having to pay something on co-signed loans because the primary borrower fails to make payments on time.
Rather than co-signing on a loan, think instead about lending the money directly. If you can’t afford to lend the money or don’t think you would get it back or don’t want to lend money to a family member, don’t co-sign.
If you do co-sign, you become legally obligated to repay the loan if the borrower doesn’t pay. Here are three big reasons this should be avoided:
1. The loan will appear on your credit report and it will impact your credit score and your ability to borrow in the future. Even if the primary borrower makes all the payments on time, the debt impacts your utilization ratio and debt burden. (Utilization ratio compares the amount you owe to your total credit limit; a low ratio, where you have a lot of available credit but little debt, is good for your credit score.) When you apply to borrow in future, lenders will think the co-signed debt is your debt.
Even worse, if the primary borrower misses a payment, your credit score could take a big hit. A single payment that is 30 days or more delinquent could take 90 to 110 points off your credit score and that will stay on your report for seven years.
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2. The lender could collect from you before collecting from the primary borrower. That may not seem possible, but it is perfectly legal in many states. And it should not be surprising. The bank believes that you can pay, but the borrower can’t.
3. The lender could sue you for repayment and you could end up having your wages garnished. Your Social Security benefits or tax refunds could be garnished, too. And you would be sued not only for the balance borrowed, but also legal fees, late fees and interest.
Co-Signing Car Loans and Student Loans
There are a few unique and important risks associated with co-signing on auto loans and student loans.
People often assume they have limited risk when co-signing for a car, figuring that if the primary borrower stops paying, the bank will just repossess the auto. However, there are two problems with this assumption.
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First, if you’re the co-signer, the repossession will appear on your credit report as if it happened to you. That can crush your credit score.
Second, automobiles depreciate in value quickly and the proceeds from a repo are often insufficient to cover the balance of the loan. If that happens, the bank can try to collect the shortfall (the amount still owed after the repo) from you, the co-signer, and can even sue you and garnish your wages.
Student loans are especially dangerous for co-signers. It is almost impossible to discharge student loan debt in bankruptcy, which means the borrower’s debt will be with you until you die. Student loan servicers regularly garnish Social Security payments and tax refunds. You could see a significant portion of your disposable income garnished until the debt is paid off.
Co-Signing to Build a Credit Score
Sometimes, people co-sign to help a relative build a credit score. But you don’t need to co-sign on a credit card or loan to do that. Instead, recommend that your child or other relative get a secured credit card at a bank or credit union. You can comparison shop for secured cards here.
With a secured card, the cardholder puts down a deposit — say, $500 — which will typically become his or her credit limit. Almost anyone can be approved for a secured card, because there is no credit risk to the bank. Secured cards build a person’s credit score, because they look like regular credit cards to credit bureaus.
If the secured cardholder makes one small purchase every month (never more than 20 percent of the available credit) and pays on time, his or her credit score will increase rapidly over time. In as little as a year, there can be meaningful improvement in the score.
If you’ve already co-signed on a loan, check your credit report regularly as a precaution. You can download yours for free once a year from all three credit bureaus at Annualcreditreport.com.
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