It’s surprising how many people with an otherwise spotless credit and payment history will suddenly decide to risk it all by cosigning a loan for a friend or relative. The motivation is always with the best intentions; it’s to help out your spouse or significant other, a parent cosigning for one of their kids or a doting grandparent stepping in when mom and dad aren’t available.
Let’s be clear; the person who needs the loan is being denied credit because the lender doesn’t believe the borrower will be able to pay it back. Looking at the borrower’s credit history through the lens of coldly calculating metrics drawn from other people who defaulted on loans, the lending institution says no way. Denials can seem arbitrary, denials can seem unfair and spur the instinctual protective desire that helped our species survive through some very tough times. Yet, the only financially sane course is to overcome that instinct.
To avoid getting drawn into the co-dependent trap of cosigning a loan and hoping for the best, remember these four key points.
Their Debt, Your Debt-To-Income Ratio
Even though the loan is in someone else’s name, the loan balance can still count against your debt-to-income ratio. It’s hard to predict our financial future three, four or five years down the road when a move, job loss or illness can suddenly arise.
If They Die, You’re Still Responsible
If you’re really determined to take on someone else’s debt, at least make sure to take out a term life policy in case something happens to them. That way you’ll have enough to pay off the loan balance in the event of their untimely death.
There’s Little Recourse If They Default
By cosigning a loan you’re accepting financial responsibility if the borrower stops paying. That includes responsibility for missed payments, late fees and collection costs if the borrower defaults. Even if you have a side contract, it’s probably a long shot you’ll ever be able to get your money back. After all, if they couldn’t pay the bank, where are they going to get the money to pay you?
Not Really Helping The Borrower
Probably the most insidious aspect of cosigning a loan is you’re not really helping the borrower address the underlying reasons they needed a cosigner in the first place. Where it can be particularly difficult are situations like student loans, the most stubborn and virulent type of debt there is, when not signing might mean your child or grandchild may have to skip a year of college. I would maintain you’re not doing them any favors adding your name to their student loans.
There are better alternatives and it pays to think through the other possibilities. Instead of cosigning a big loan, help the borrower rebuild his or her own credit. Maybe cosign for a series of small bank loans, $500 to $1,000, that will help the borrower build up their credit rating.
Helping them organize their finances and learn to manage money is going to be a far more valuable long-term life skill than cosigning a loan. It’s perfectly reasonable to see how they behave on a site like Mint.com, which is free, before you decide to commit your name to a loan. If they can’t manage money, cosigning a loan really isn’t going to help them.
Another option is to steer them to peer-to-peer lending with lender pools like Prosper and LendingClub. Again, start them off with small loans and encourage them to pay the balance off ahead of time. If they build up a good borrower reputation on Prosper with small loans, they’ll qualify for a better interest rate when they need a bigger loan.
Student loans are tougher but it still might be in their best interest to take a year or two off college and work to build up their credit rating or earn enough money to go back to school part time, though rising tuition makes that more difficult. It’s also prudent to at least consider that not everyone is meant for college.
It’s certainly difficult when kids come to you in need but stay focused on the fact that cosigning a loan is more like giving the bank a hostage. Instead of one person with bad credit, the odds are the story will end with two people with bad credit.