It happens to many of us. At some point, a friend or family member calls you and asks to have coffee. A few awkward minutes into the awkward conversation, you are asked to co-sign onto a loan.
In the wake of the Great Recession, banks toughened their requirements for all types of loans. Borrowers must meet strict income and credit requirements, and many cannot meet these without some help. Banks are more likely to grant someone a loan if the loan is co-signed, meaning that the co-signer is responsible for paying back the bank if the primary borrower defaults.
While it is temping to immediately rush to help a friend or family member, you should first understand your obligations, and know what might happen if the person you are helping with your signature fails to repay the loan.
Co-Signer or Co-Borrower?
Two terms describe a person who helps someone else get a loan: Co-signer and co-borrower. A co-signer and co-borrower both:
- use their good credit and income to help someone else get a loan
- are legally obligated to make the loan payments if the other borrower fails to do so
- can be sued by the lender (typically a bank) if the other borrower fails to make payments, and
- can sustain damage to their credit history if the other borrower is late in making payments or misses payments entirely.
However, there is one important difference: A co-borrower is listed on the title to the property bought with the loan money, like a car or a house. This means the co-borrower actually co-owns it. A co-signer is not listed on the title. He or she has no legal claim to the property. (Some would say that this means that the co-signer has all the risks with none of the benefits!)
Be Prepared Before Agreeing to Co-Sign or Co-Borrow on a Loan
Assuming you want to take on the risk, there are some factors to consider before saying "yes" to your friend or family member. It's best to draft an agreement or contract between you and the other borrower. This document should include details about:
- who is responsible for making the payments
- how much the payments will be, by when they are due, and where they need to be paid
- what happens if one borrower doesn't make payments and the other borrower takes over payments; will the first borrower sign over his or her ownership interest in the property to the co-borrower?
- whether, if one borrower is initially relying on the co-borrower/co-signer for purposes of good credit history, the loan will be refinanced later to have the co-signer/co-borrower taken off the loan, and
- who is responsible for paying legal costs and fees if one borrower has to take legal action against the other.
Talk to a lawyer if you need help writing the contract. A savvy lawyer can help make sure all of your bases are covered and your good deed does not expose you to unnecessary potential liability.
What If Something Goes Wrong During the Loan Term?
In the worst possible situation, the person you tried to help might not make payments on time, or at all. When this happens, the loan goes into default, meaning the borrower has failed to meet the loan obligations.
As a co-signor or co-borrower, you face serious consequences if the loan goes into default. You may:
- be asked by the lender to pay what is owed on the loan
- be sued by the lender, or have your wages garnished to pay off the loan
- be responsible for late fees or collection costs charged by the lender, and
- have the late or missing payments, or a court judgment against you, reported to the major credit bureaus, resulting in damage to your credit rating.
To protect your credit history, you would need to make the necessary payments to get the loan out of default. Then, you'd want to deal with the other borrower in order to fix the problem. Here's what you have to think about:
- Can the other borrower repay you for getting the loan out of default?
- Can the other borrower continue making payments? It may be better to sell the property and repay the loan to protect your credit.
- If the other borrower can't make payments, would it be best to take over payments and ownership of the property? (If you take over payments, or the other borrower can't repay what you spent to get out of default, ask that person to sign the ownership interest over to you.)
- If you co-signed the loan and want to own the property, ask the lender about refinancing the loan to get your name on the property's title. You may have to buy the property from the other borrower or the bank.
The decision of whether to help a friend or family member is deeply personal. Regardless, it is a good idea to know exactly what you are getting into before agreeing.
Questions for Your Attorney
- Is it better to co-sign a loan or simply to lend the money my friend or family member needs?
- Should I have a contract in place with my friend or family member before co-signing a loan?
- I was never told by the bank that my friend defaulted on a loan I co-signed. Now the bank is suing me. What can I do?