What in the world am I talking about?
In short: cosigning a loan for a friend or family member.
Let’s take the case of Tom and Sue. They have a mortgage on their home and weren’t planning on moving for years (if ever). So, when one of their kids was ready to buy a home and needed a little help from mom and dad, they were thrilled to assist.
In most cases like this, we see parents providing down payment funds to their kids. In this case, the child had credit and income challenges, and the lender was requiring a co-signer. Without a second thought, Tom and Sue hopped in to help.
Fast forward nine months. Tom suffers a severe health challenge and the decision was made to sell their two-story home and purchase a home without stairs.
Much to Tom and Sue’s surprise (and dismay) they were not able to qualify for a mortgage for their new home … because they had co-signed for their child’s mortgage.
Here are some things to remember about co-signing a loan. Although in the story above Tom and Sue had cosigned for a mortgage, these issues apply whether you’re cosigning for an auto loan, a mortgage, or a line of credit.
Cosigning is a high-risk, low-reward proposition
When you cosign, you take on all the risk if the loan is not repaid. If the other borrower defaults on their loan, the lender will come after you for the payments. So, your risk is high – after all, the borrower was denied credit for a legitimate reason and the lender’s determination that they couldn’t (or wouldn’t) repay the loan.
Yes, there’s an emotional reward for helping someone in need. But if you’re thinking you’ll also benefit from boosting your credit score by cosigining, experts say this is rarely the case. Your credit score is probably already very good, or you wouldn’t have been approved as a cosigner, and you don’t need the negligible bump that cosigning might give.
The co-borrower doesn’t have a lot to lose
Your act of generosity may help the borrower immensely. But if things go sideways and they’re unable to make their payments, they won’t have a lot to lose.
They likely already have issues with their credit. As a result, they may not be very concerned with defaulting on the loan (and leaving you stuck holding the bag).
You could be risking friendships and frazzling family dynamics
In the best-case scenario, the co-borrower will make all their payments on time and as scheduled. But what if they can’t? Are you prepared for the fallout? Do you want to spend time and energy ensuring that payments are being made?
Even a single missed payment can have a profound impact on your credit. Cosigned mortgages, in particular, can leave a big black mark on your credit report.
While your desire to help someone in need is wonderful, are you willing to risk a complete loss of the relationship if the loan goes sideways and you get stuck holding the bag?
Cosigning is a long-term commitment
Cosigning for a car? Payment terms may be as long as 72 months (six years). For a home, it will likely by 30 years.
There could be tax consequences in the event of a default.
Let’s say the co-borrower defaults and you get “lucky” – the lender doesn’t want to sue you to pay the balance owed. Instead, they decide to settle and write off some or all of the debt. That could leave you with tax liability for the difference.
For example, let’s say you cosigned for an auto loan that was $25,000. Some of the payments were made, but ultimately the borrower couldn’t perform on the loan. There is a balance of $18,000 due, and the lender is willing to settle for a payment of $5,000. That probably means you are going to pay the $5,000 (since the borrower is defaulting and either unwilling or unable to pay). In addition, the difference between the balance due and the settled amount ($13,000 in this case) has to be reported to the IRS as “forgiveness” income on your tax returns. Now you get to pay taxes on this!
As if that weren’t bad enough, settling on the account will leave a negative mark on your credit report. Rather than showing as “paid as agreed” it will show as “settled”. That status will lower your credit score.
Be prepared (and truly able) to make that payment
It sounds obvious, but you’ll be making that payment if your cosigner defaults. While on paper this may be manageable, what changes would you need to make in your life to do that? What would you have to give up in order to make that payment?
And, as mentioned above, this could be a long-term situation. Some experts recommend setting aside twelve months of payments in an emergency account (and hoping you never have to access it!).
Go in with your eyes open
There’s little doubt that cosigning is on the rise. In 2017 (the most recent year for which data is available), 22.8% of home purchase loans included a cosigner – up from 21.3 in 2016, according to ATTOM Data Solutions (a real estate data company).
Cosigning a loan seems like a kind and generous act – and it can be. In some cases, it will make sense for you to cosign.
But before you do, consider the risks and search for alternative options to help your friend or family member.
Keep the lines of communication open. Failing to do so could leave a black mark not only on your credit, but also on your friendship.