Important Risks to Consider Before You Co-Sign A Loan for Someone
There are several reasons behind why a person would want some extra money, from buying a house, to starting a business, or expanding an existing one. But getting a loan has a lot of constraints attached to it. Several aspects need to be understood before applying for one.
A loan can be money, property, or any other material goods given to a party with a promise of future repayment of the loan value, usually along with an interest. It is typically issued by financial institutions such as banks, as well as by corporations and governments.
In simple terms, a loan is the lending of money by one or more individuals, organizations, or other such entities to another person or organization to be repaid with an interest within a specified period.
What are the Different Types of Loans?
When you borrow money, it can be used for countless purposes as intended, from investing in a business, to buying a new car, or even an engagement ring. There are numerous kinds of loans available, and some of them include the ones mentioned below:
Personal loans are loans taken for largely personal reasons, and they do not have a designated purpose. This feature makes them an attractive option for many, especially those with outstanding debts and who’d like to reduce their burden.
When you pay with a credit card, you are essentially taking a personal loan. Credit cards are short term loans that are usually paid off within a month without interest (if paid immediately). If the amount remains unpaid, it accrues interest, which is charged every month until the debt is repaid.
The main difference between a credit card and personal loan is that, unlike a personal loan, the credit card has a limit, and the card owner can borrow repeatedly without paying interest (as long as the amount is repaid on time). In other words, the credit card represents revolving debt.
You probably know that your house is worth more than the mortgage you owe if you have equity on your home, right? But were you aware that you can borrow against the equity to pay for other things, such as consolidating credit card debt, house renovation, and repayment of student loans, among others?
Home-Equity Line of Credit (HELOC)
The home equity line of credit (HELOC) works just like a credit card, but it uses your home as collateral. As a result, the interest levels are comparatively lower. The major difference is that, unlike credit cards, with HELOC, the interest rates are variable, and it also offers flexible repayment.
This is simply a short-term loan against your credit card wherein you withdraw money from a bank or an ATM. It is an expensive loan option, as it charges a higher interest rate than credit card purchases.
Small Business Loan
Small business loans are typically sought by those who intend to set up a new business or expand an established one. For such loans, you must submit a formal business plan to the bank for review, which can be difficult.
There are several other types of loans, such as:
- Mortgage loans
- Car loans
- Student loans
- Debt consolidation loans
- Payday loans
- Veteran loans.
Each classification has different requirements, as well as varied interest rates. As interest rates are forever-fluctuating, it’s always better to be updated before applying for a loan.
Factors that Impact a Loan Application
When you read any piece of information regarding a loan application, everything may seem straightforward. But did you know that several factors can impact your loan application? These vary depending on the type of loan desired. Some prerequisites of a loan application that may influence your loan processing to a significant extent include the following:
- Proof of income: You may lie about your income to your family and friends, but if you need a loan, an oral statement is not sufficient. You must submit proof of income to the lender, be it in the form of a bank statement, old tax forms, or a salary slip.
- Employment history: Your employment history affects your loan application too. If you’ve been changing jobs quite often, there’s a possibility that the lenders perceive you as unstable and reject your loan application eventually.
- Housing history: Just like your employment history, if you often move from one area to another, you will be considered an unstable candidate, as it increases the lender’s chances of not being able to locate you in case of a failure to pay back the loan.
- Debt to income ratio: If you already bear a huge debt under your name, the possibility of getting more loans approved can be a hassle if your debt-to-income ratio is high.
- Recent repayment history: If you’ve had a prior debt, lenders may want to judge you based on your repayment history. If there were one or several instances wherein you failed to pay on time, your loan application may be at risk.
- Potential collateral: Depending on your income and other debts, you may need an asset, a property, inventory, or equipment as collateral to ensure that your loan is not at risk.
- Credit score: The possibility of your loan being approved is high when you have a high credit score. A good credit score makes you eligible for several types of loans, such as car loans, mortgage, and a credit card. It also justifies low-interest rates and hassle-free application processing.
While most of these factors can put your loan application at risk, some have a solution – a co-signer.
What is a Co-Signer?
The simplest definition of a co-signer is someone who agrees that, should the borrower default on the loan, they will pay the debt to the lender. Without a co-signer, many people would have difficulties getting a loan approved, especially first-time borrowers.
A borrower’s odds of loan approval improve greatly if they have a co-signer with a good credit score and an extensive credit history. Despite treading in dangerous waters, co-signers are of great help to borrowers who otherwise would not be granted a loan.
If you are a co-signer, the lender will provide in writing your obligations when you co-sign a loan, known as the co-signer’s notice. The obligations put forth by the lender will state the following:
- You, as a co-signer will guarantee the debt, meaning, if the borrower fails to repay the debt, you must be ready to do so. It is ideal to think twice before you co-sign and be sure that you can afford to pay if you have to.
- You must be prepared to pay the debt in full along with the late fees or collection costs.
- The creditor can approach you to collect the debt even before going to the borrower. The same collection method as that of the borrower applies to you, which includes suing or garnishing your wages. The particular notice changes from one state to another. Your state may forbid the collector from collecting from you before approaching the borrower.
- If the debt is ever in default, it may become a part of your credit record, deterring your chances of getting a loan.
- The notice provided by the creditor is not the contract that makes you liable for the debt, but by co-signing the loan application, you give your approval to the co-signer’s notice.
As an applicant, having a co-signer is not a bad idea. A co-signer helps the applicant obtain finance and also helps build credit. But being a co-signer for a loan applicant has several risks.
Risks of Co-Signing on a Loan
It is a great to be of some assistance to someone in need. Helping an individual get a loan by being their co-signer is rewarding, but it is critical to understand the risks associated with being a co-signer. Most times, lenders approve the loan based on the co-signer’s capacity to repay the loan if the borrower defaults.
If a creditor or lender is uncomfortable approving a loan to a borrower, they must have a good reason, and as a co-signer, you must justify your willingness to take the risk. The downsides of co-signing a loan application greatly outweigh the benefits.
The risks of co-signing a loan for someone include the following.
You will increase to your debt to income ratio.
A debt-to-income ratio is the percentage of debt payments in relation to the borrower’s income and is calculated by dividing the monthly debt payments by the monthly income. Unfortunately, many people fail to understand that co-signing negatively impacts their own debt-to-income ratio.
A co-signer is always attached to the loan since it isn’t a verbal agreement. Irrespective of whether the primary loan applicant makes the payment or not, if you are a co-signer, the loan is reflected in your credit report. The monthly loan payment that reflects in your report influences your debt-to-income ratio.
You cannot remove yourself as a co-signer.
As stated above, being a co-signer is not a verbal agreement. As a co-signer, you are required to sign the loan documents, which attaches you to the loan until it is repaid in full. In simple, being a co-signer is not something you give consent to for a couple of months. Rather, it is a responsibility that, once accepted, must be fulfilled.
Once you sign the loan document, you are bound to a contract that cannot be revoked no matter what. Remember that you’re simply unable to take your name off the contract.
You can damage your credit.
There is a reason why a person does not qualify for a loan on his or her own. Although it’s a good deed to help someone in need, you must understand that, by doing so, you may be damaging your own credit. A person who requests you to co-sign may be a defaulter on a loan or may be paying his or her bills late.
It is important to note that history may repeat itself again, resulting in your credit score suffering the consequences as the loan appears on your credit report. Any missed or late payment by the primary applicant reflects on your credit report. Is it worth the financial and credit risk?
You may face legal actions.
As a co-signer, you are responsible for ensuring that the primary loan applicant pays his or her dues, failing which, you are entitled to repay the loan yourself. If you refuse to make the payment in full, lenders can claim assets from your bank account and garnish your wages.
They also have the right to take legal action against you, which may inflict a huge impact on your life. To add to this, the attempts made by the lenders to recollect the loan will reflect in your credit reports, further damaging your credit score.
It is a high-risk low reward responsibility.
Being a co-signer is just full of responsibilities without any benefits. As a co-signer, you do not have any rights on the loan amount or on how it’s spent. You also do not own whatever the primary loan applicant buys just because you’ve co-signed the loan application. All you own is the debt if the primary loan applicant fails to repay it.
As a co-signer, you will face a host of perils and may confront legal responsibilities in case of any failure in repaying the debts, either by you or the primary loan applicant. It is advised against co-signing a loan application if you are unwilling to take all the risks.
You are liable to pay a significant amount.
Did you know that a co-signer is liable to pay in full the debt owed by the primary loan applicant if he or she fails to make the payment? As a co-signer, you legally agree to fulfull the loan amount. Lenders will not agree to a partial repayment only because you aren’t the borrower.
When you co-sign the loan agreement, you make a legal promise to satisfy the requirements of the agreement if the primary applicant fails. It only means that you are indebted to pay it in full, which usually is a significant amount that can hurt your income and finance.
The tax consequences may be huge.
Let’s assume that the lender does not want to take legal action and go through a lengthy process and instead agrees to settle the debt owed. The lender agrees to close the loan after you pay the agreed percentage of the loan. In such cases, you could have tax liability for the difference.
For example, if the loan amount is $50,000 and you pay $35,000 as a co-signer, you are entitled to report the other $15,000 as “debt forgiveness income” on your tax returns. This action also leaves a negative mark on your credit report, as it will state “settled” instead of “paid as agreed.” The remark will bring down your credit score.
Keeping track is an added responsibility.
As a co-signer, you must always be aware of the primary applicants’ actions and ensure that the borrower makes timely payments and does not default on any. You must also encourage the borrower to organize and prepare to pay the loan.
Your access to credit is limited.
When you are a co-signer, the loan borrowed by the primary applicant reflects on your credit report. This is one of the long-term risks of co-signing, as any default can affect your chances of borrowing. If the day comes when you may need to apply for a loan, your credit score, which has suffered the consequences of a borrower’s non-repayment, may lead to a rejection of your loan application.
It can destroy personal relationships
Last but not the least, being a co-signer can destroy several relationships, starting from the borrowed to your own family. There are several other instances, such as: children who fail to repay a co-signed car loan or credit card that may hide the problem until it worsens; and couples going through a divorce may have to face financial consequences, and it may be tough to convince the spouse to make payments and such.
If the borrower fails to repay the loan, you are burdened with the repayment, causing a strain on your relationship with the borrower. As you are indebted to pay in full, you may put yourself into financial trouble that may damage your relationship with the borrower, who might be a family member as well.
In very few loan agreements, the lender includes a co-signer release clause in the loan agreement. The release clause lets you remove yourself as a co-signer once the primary loan applicant demonstrates a history of appropriateness. The only other way to remove yourself as a co-signer is through refinancing by the primary loan applicant.
Being a co-signer is a huge responsibility. It is advised to weigh the consequences before you sign a loan application to help your loved ones.