When a borrower has a poor or tarnished credit score, there are few options to get financing. One is to ask a friend or relative with good or excellent credit to co-sign the loan.
The Responsibilities of the Co-signer
As a co-signer, you are responsible for loan repayment in case the borrower is unable to cover his payments. Non-payment and late payments may also affect your credit score. This will increase the premiums paid on your homeowners and auto insurance. Moreover, financial institutions often call the co-signer first if they believe that he will be able to make payments. Another problem is that for other financial institutions, it looks like you are borrowing more. This may make it more difficult to get approved for a loan or mortgage.
What is more, you will be sued first if the borrower fails to make payments. The reason is that your credit score is higher. Thus you are more likely to repay the outstanding balance. The borrower already has bad credit and nothing to lose except your friendship. If the borrower negotiates a debt settlement, the co-signer will face tax consequences. For example, if the borrower owes $15,000 and settles for $8,000, a debt forgiveness income of $7,000 must be reported on your tax returns. Moreover, the financial institution has the right to garnish your wages and file a lien in case you are unable to make payments. How likely is it that you will be held responsible for repayment? One study shows that in case of default, about 75 percent of co-signers are held responsible and asked to pay first.
Alternative Solutions
One option is to lend or gift them the amount required. Another option is to offer money for the down payment to help them qualify for a mortgage. Offering a larger down payment increases the borrower’s chances to get an attractive interest rate and makes the monthly payments more affordable. A land contract is yet another option for those who can purchase the property themselves. In this case, both parties sign a contract that is called contract for deed. You may consider opening a joint savings account to keep money worth a few months of loan payments. Make sure that your signature is required to make withdrawals.
Minimizing the Risk
If you co-sign for a friend or family member, it is important to limit the risk. To this, get online access and keep track of all loan payments. You may also request that duplicate statements are mailed to your home on a regular basis. Ask the financial institution to contact you immediately in case of non-payment or missed payments.
What to Do in Case of Default
As a co-signer, you have few options left. You have the right to sue the borrower but that doesn’t mean that they will be able to pay you back. If the other party is unemployed or files for bankruptcy, you will be responsible for repayment. Your best bet is to use the services of a law firm or a debt collection agency.
Co-signing a Credit Card
This is even riskier because you have little control over the borrower’s spending. Many parents do this to help their children to establish credit. The problem is that they often end up with tarnished credit because of their child’s poor money management habits. Applying for a secured credit card is a better solution because the limit is usually equal to the deposit made. Cardholders have a good chance of getting approved for a regular credit card once they have established a record of timely payments.
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