You ask excellent questions about the risks of co-signing on a loan.
The Co-Signer and Financial Responsibility
Although you may want to help a family member or friend who cannot qualify for the loan without a co-signer, it is important for you to understand what your obligations are when you co-sign on a loan. When you co-sign a loan, you take responsibility for repaying the loan if the primary borrower does not. This means you may repay the loan plus any late fees, interest, or other charges the lender has added if the lender cannot collect from the borrower.
FTC Rules About Co-Signing
According to the Federal Trade Commission (FTC), a co-signer must be presented with a detailed disclosure by the lender before he or she co-signs for the loan that explains the co-signer’s obligations.
The disclosure reads, "You are being asked to guarantee this debt. Think carefully before you do. If the borrower does not pay the debt, you will have to. Be sure you can afford to pay if you have to, and that you want to accept this responsibility.
"You may have to pay up to the full amount of the debt if the borrower does not pay. You may also have to pay late fees or collection costs, which increase this amount.
"The creditor can collect this debt from you without first trying to collect from the borrower. (Depending on your state, this may not apply. If state law forbids a creditor from collecting from a cosigner without first trying to collect from the primary debtor, this sentence may be crossed out or omitted altogether.) The creditor can use the same collection methods against you that can be used against the borrower, such as suing you, garnishing your wages, etc. If this debt is ever in default, that fact may become a part of your credit record.
"This notice is not the contract that makes you liable for the debt."
As the disclosure explains, the co-signer is exposed to a lot of potential financial harm. Remember, even if the person you co-sign for has every desire and intention to repay the debt, if circumstances arise that make his/her repaying impossible, the co-signer is on the hook. Loss of income or job, an illness, or some other unforeseen event could impede the person’s ability to pay, leaving the co-signer the only with means to pay it back and fully liable to do so.
According to the FTC, "Studies of certain types of lenders show that for cosigned loans that go into default, as many as three out of four cosigners are asked to repay the loan." The only reason the borrower is being asked for a co-signer is that the lender decided that the risk was too great to offer the loan without one. Sometimes, this is not due to the borrower having a poor credit history of bad payments, but due to the fact that the borrower has never had credit before. Having a loan co-signed for, if the loan is paid back as agreed, is a great way for a person without credit to establish credit worthiness, though that does not lessen the co-signer's responsibility in any way.
The Effect on Credit for the Co-Signer
Another impact you asked about was effect on the co-signer’s credit. There are two main effects. First, it will appear on your credit report, much like any other debt. If payment is late, for instance, that derogatory notation will appear on the your credit report, lowering your credit score. This can happen well before the co-signer has any idea that there is a problem, as the co-signer does not often receive a monthly billing statement.
Secondly, because the co-signed loan shows on the co-signer’s credit report, it may prevent the co-signer from obtaining credit. If a co-signer is planning to buy a house, car, or other large purchase during the life of the co-signed loan, it is a good idea to think about the implications. For instance, it is prudent to consider whether the co-signed loan would negatively affect the co-signer’s debt to income ratio and be a reason for not qualifying for the desired loan, even if all payments are made on time on the co-signed loan.
If You Decide to Co-Sign
Despite the risks involved, a person may decide to co-sign a loan, to help out a friend or family member. If the decision is made to co-sign, here are some things to keep in mind.
- Be certain that you can afford to make the payment on the loan, while maintaining your other financial obligations. If you cannot, you increase the risks that you could end up suffering collection efforts, including a wage garnishment, along with your credit rating suffering.
- If you are asked to pledge anything as security, such as a home or car, be aware that you could lose the asset, if the borrower defaults and you are not able to pay back the loan.
- You can make certain requests from the lender, which can offer you a degree of protection, though the lender does not have to grant them. For instance, you can ask the lender to make it so that you are responsible only for the principal of the loan, so you are not liable for late charges and collection fees. You can also ask that the lender notify you if a payment is late, so you can try to fix the problem before it gets out of hand and hurts you. In either of these cases, get the assurance from the lender in writing, or it is not going to help you.
- Keep all the records and paperwork associated with the loan. This way, if there is any dispute, you have records. Because the lender is not required to give these records to you, make sure to get copies from the borrower.
- Because rules can vary from state to state, check with the consumer rights department in your state of residence.
The FTC details facts for consumers about co-signing.
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