Lending a hand to close family members when they ask for help is a natural inclination. This generosity is often demonstrated when relatives agree to co-sign a loan. But entering into any arrangement involving money requires careful consideration; cosigning a loan is a big financial commitment.
In this article, we're going to be talking about the pros and cons of cosigning a loan. That discussion will include the factors to consider before helping, as well as the long-term impact this type of arrangement can have on both parties' personal finances. We'll also cover several specific examples such as student loans, mortgages, and car loans.
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Before signing any agreement, it's important to understand the "fine print." This holds especially true for legal contracts that involve a loan. In fact, lenders are required to provide notices containing the following key points:
When someone agrees to co-sign on a loan, they are essentially stating they will guarantee repayment of the money owed to the lender. This commitment is binding if the borrower cannot meet this financial obligation, or if they simply refuse to continue payments.
The benefits of these agreements always favor the borrower, while the cosigner assumes all risk of repayment. There are three benefits that usually flow to the borrower:
As mentioned earlier, all of the disadvantages of this type of arrangement flow to the cosigner. In addition to guaranteeing the loan, being the focus of collections activities, and paying fees, the cosigner takes on two additional risks. Since repayment now becomes their responsibility too, they may not qualify for a loan they might have otherwise. In addition, a poor pattern of repayment will adversely affect the credit scores of both the borrower and the cosigner.
Studies cited by the Federal Trade Commission indicate that as many as 75% of cosigners are eventually asked to help repay the loan. Lenders will only require borrowers to find another party when they believe the risk of default is high.
Fortunately, there are several steps a cosigner can take to lower their risk if the borrower stops making payments on the loan. A good friend or family member will understand if the cosigner requests proof of payment each month. Asking for the monthly payments to be automatically withdrawn from a bank account, and a confirmation of that payment sent to an email address is also a reasonable request.
Lenders will often agree to notify the cosigner in the event payment is not made on time. These notifications allow for additional time to investigate the problem, thereby lowering late payment charges.
Finally, the cosigner is also entitled to understand the finances of the borrower. This includes liquid assets, such as bank account balances, as well as all sources of household income.
The typical cosigner on a student loan is a spouse, parent, guardian, or relative such as a grandparent, aunt, uncle, or cousin. Student loans are unsecured. There is no asset, such as a house or car, that can be sold to help pay off the loan's balance if the borrower goes into default.
For this reason, unsecured loans are considered riskier than secured loans. Additionally, most students will not have a reliable source of income until after they graduate from school. Anticipating this problem, parents are often financially prepared to help their children with their student loan payments immediately after graduation.
Interestingly, organizations such as Sallie Mae encourage students to obtain a co-signature for their loans. Doing so allows the student to qualify for a better interest rate too.
Fortunately, Sallie Mae also recognizes that students eventually find jobs, and have incorporated into their loans a cosigner release. For example, it's possible to obtain a release once the borrower successfully makes 12 consecutive on-time payments on a SmartOption Student Loan.
A loan for a car or mortgage is considered a secured loan. If the borrower defaults on the loan, the lender can repossess the car or foreclose on the home. The lender can then sell the home or car to recover some of the money owed. Therefore, secured loans offer lenders an added layer of protection against the risk of default.
If the lender requires the borrower to obtain a cosigner before writing a car loan or mortgage, then it's very likely the borrower does not have the financial resources to obtain the loan. Buying a home is typically the largest financial commitment a person makes in their lifetime. It's important to make sure the borrower really has the ability to repay the money owed.
For this very reason, many financial experts advise against ever cosigning a loan. Perhaps the best advice a person could give to a friend or family member is to find a home or car that fits their budget.
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