A co-signer on a loan is typically required when the lender is concerned that the primary borrower will not pay back the loan. A common situation is a young adult’s first car purchase – most young adults don’t have the money to pay cash for a car so they need to take out a loan. It’s often their first loan, so the young adult is perceived as a potential default risk because he or she doesn’t have a history of making payments. The lender simply can’t evaluate how likely the young adult is to pay back the loan. So a parent or other family member will co-sign for the loan.
It sounds simple, and can work well if the loan is paid off timely and in full. In the above example, when the car loan is paid off, the young adult will have a credit history that will be looked upon favorably by subsequent lenders. Therefore, the young adult will hopefully not need a co-signer for any future loans, and in fact, will be able to co-sign his or her own child’s first car loan in the future.
However, co-signing a loan doesn’t just mean that you’re attesting that you believe the primary borrower is responsible and will pay back the loan. It means that you, the co-signer, may become responsible for paying back the entire balance. According to the terms of the loan, you are not the person to whom the money is being lent. However, by co-signing the loan, you are agreeing to pay back the balance owed if the person to whom the money was lent stops making payments.
Thus, in the above example, if the young adult fails to make payments, the lender will go to the co-signer and demand that the co-signer make the payments instead. For parents who probably would have paid for their child’s car anyway, this may not be a big issue.
But suppose circumstances were different. Imagine a relative or good friend who is trying to buy a car so he can get to work. You’ve known the person for most of your life. He has always been responsible and trustworthy, you know he needs the car in order to keep his job, and his job pays more than enough to allow him to make his car payments. So it’s incredibly difficult to refuse when he asks if you will co-sign the car loan for him.
Again, if he makes all of his payments and pays off the loan, you simply feel good for helping out a loved one. But suppose your relative or friend loses his job. Suddenly, he doesn’t have the income he needs to make the car payments. Maybe he could sell the car and pay off the loan. But if he keeps the car – perhaps so he can get around to look for a new job – and stops making payments in the meantime, the lender can demand that you make the payments for him.
If you can’t afford the payments either, or if they present a significant financial hardship for you, then your financial position will be compromised as well.
Even if you can afford the payments, you may find yourself in court if the lender sues you to recoup the loan (and the lender will likely sue you before your relative or friend, simply because you are more likely to have the ability to pay). If the lender settles the loan without suing you or giving you a chance to pay off the balance, you may have to report the difference between the amount owed and the settlement amount as “cancellation of debt” income and pay taxes on it. Having a settled account on your credit report could also lower your credit score, which could make it difficult for you to obtain a loan for yourself, or require you to pay a higher rate.
This is the nightmare scenario that experts envision when they advise against co-signing for a loan. In addition to possibly risking your own financial security, you risk your relationship with the person for whom you co-sign. After all, can you imagine remaining on good terms with a friend or relative who refuses to sell the car to pay off the loan and makes you pay for the loan instead?
If you decide to co-sign a loan anyway, you can attempt to minimize the risk to you by having the loan contract require the lender to notify you if the borrower misses or is late with a payment (this will allow you to contact the borrower immediately instead of waiting for the lender to recover the balance from you). You can also ask the lender if you can limit your liability to the balance of the loan itself, so that you are not responsible for late fees or collection fees.