You love your kids, right? So what do you do when Junior unveils a financial plan at dinner that nearly makes you gag on your pork chop?
Junior, who graduates from college in the fall, wants you to co-sign a $25,000 car loan so he can buy his dream machine from the local Honda dealer. It will give him a great start in the working world, he says, and how could you not hope for that too?
Simple. As much as you want to help your son launch his new career, you suspect that co-signing a car loan is a terrible idea. After all, you just finished paying his college bills, and your bank account says it’s time to hit the brakes on doling out money to Junior.
Family members often find themselves in situations like this, and it’s a risky place to be.
Surveys suggest that more than a third of loan co-signers are stuck with the debt when the primary borrower stops paying. When one party to a co-signed loan defaults, the other is responsible for the balance.
It gets worse. If you co-sign a loan and the other party dies, it becomes your debt. If you have assets and the person you cosigned for doesn’t, the lender probably will sue you first if the loan goes into default.
It might be hard to say no to a family member, significant other or close friend who asks for you to cosign. They’ll tell you how much they need whatever it is they want to buy and that they won’t let you down.
But remember, whether it’s for a lease, a mortgage, a credit card, or a student or car loan, co-signing is essentially risk without reward. Your co-signature obviously helps the person get a loan, and lenders are more than happy to bring you into the deal if they believe your assets safeguard the money they loaned.
Princeton Survey Research International Associates conducted a poll of 2,003 U.S. adults in early 2016 that found that 38% of co-signers were forced to pay all or part of a loan. Twenty-eight percent of the co-signers suffered a drop in their credit score as a result of the primary signer’s late payment or default. And more than a quarter said their relationship with the signer suffered as a result of the arrangement.
Even if the borrower makes payments, the fact that your name is on a debt can impact your credit score. The debt shows up on your credit report, and the use of credit counts for 30 percent of your score. Having your name on a co-signed loan also increases your debt-to-income ratio because you are liable for the loan once you sign it. That, in turn, can make it harder for you to borrow for yourself if you need to.
This, surprisingly, doesn’t stop people from co-signing loans. The Princeton Survey poll found that one in six American adults have co-signed a loan. Typically, they are older than 50 and are co-signing a car loan for a child or close family member.
There also could be tax consequences for co-signing a loan. If the borrower can’t pay the loan and convinces the lender to accept a settlement, the Internal Revenue Service won’t count the forgiven debt as your income. For example, if the borrower racked up a $15,000 debt on a credit card you co-signed and the lender accepted a settlement for $7,500, the borrower might have to treat the forgiven $7,500 as income. But if you never used the credit card or benefitted from purchases made with it, you wouldn’t have to pay tax on the forgiven money yourself. Recognizing your unique role in the debt, the IRS considers you a guarantor and not a debtor.
You also might be entitled to deduct interest paid on a co-signed loan in certain cases. For example, the parent of a student who is making payments on a student loan can deduct the interest if the parent claims the student as a dependent. If the student isn’t claimed as a dependent, the parent can’t deduct the interest even if the parent pays it.
Before considering co-signing a loan, make sure you’re capable of repaying the loan if the primary borrower defaults. Perhaps a better idea is giving the friend or family member a personal loan for part of what they need. Perhaps a lender is willing to loan no more than 50 percent of what is needed to buy a boat. You could loan the remainder necessary, enabling the borrower to make the purchase, but avoiding the risks associated with co-signing.
You could try convincing the would-be borrower to defer the purchase requiring a loan, then working with them to improve their credit score. You might also encourage them to supplement their income with part-time employment, giving them more borrowing power. In this case, they might get the loan they want and you can stay off the loan application.
Finally, if you co-sign a child’s or relative’s private student loan – a very common practice – make sure you look for loans that come with a co-signer release. Releases generally release the co-signer from liability after a certain number of payments have been made on the loan. If the student loan has a release clause, the co-signer should file for release as soon as possible.
This step not only benefits the co-signer but the borrower. The Consumer Financial Protection Bureau has warned that some private student loans will automatically go into default if the co-signer dies or becomes bankrupt, even if payments are made on time. Releasing the co-signer safeguards against that happening.
Things to consider before you decide to co-sign a loan:
Kossman, S. (2016, June 5) Poll: 4 in 10 Co-signers Lose Money. Retrieved from: http://www.creditcards.com/credit-card-news/co-signing-survey.php
Chopra, R. (2014, April 22). Consumer Advisory: Co-signers Can Cause Surprise Defaults on Your Private Student Loans. Retrieved from: http://files.consumerfinance.gov/f/201404_cfpb_consumer-advisory-co-signer-release.pdf
Harelik, J. (ND) Top 10 Reasons Not to Co-Sign on a Loan. Retrieved from: http://www.bankrate.com/finance/debt/reasons-not-to-co-sign-loan.aspx
NA, ND. Co-signing a Loan. Retrieved from: https://www.consumer.ftc.gov/articles/0215-co-signing-loan
Herigstad, S. (2014, July 11). For Co-Signers, IRS Won’t Count Forgiven Debt as Income. Retrieved from: http://www.creditcards.com/credit-card-news/irs-forgiven_debt-income-co-signers-1294.php