The Perils of Co-signing a Loan

Can you afford to make those loan payments if the borrower defaults?

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Being a co-signer isn’t like giving a person a reference on a job application. You’re not just vouching for the borrower’s ability to repay the debt, you are vowing to pay 100% of the loan yourself if the borrower defaults. You are taking the risk that a professional lender is not willing to take.

Can you afford to make those loan payments if the borrower defaults?

Co-signing a Personal Loan

As a loan co-signer, you would be wise to monitor the borrower to be sure payments are made in a timely fashion. Such oversight might cause friction between you and the borrower, even more so if payments are late or if the loan is in default. If payments are not made the lender might sue you first, presumably because you have better credit and more resources. If the debt is settled, you could face tax consequences. Forgiven debt is considered income and is subject to tax. To worsen matters, a “settled” account might negatively affect your own credit score. What if a settled debt you co-signed for a friend prevents you from getting a loan you personally need? Even a co-signed loan in good standing can affect your ability to get financing as it counts the same as your own loan and affects your debt-to-earnings ratio.

Special Considerations for Co-signing Student Loans

When a young person who has a student loan dies, this terrible circumstance may be further worsened when the loan debt falls onto the shoulders of his grieving co-signers, presumably parents or other relatives. Student loans granted through Sallie Mae after 2009 include a provision that discharges the debt if the borrower dies. However, this is not the case with private student loans. Even bankruptcy cannot discharge student loan debt, so be wary of your commitments.

One practical option to prevent this situation is for the co-signer to take out a term life insurance on the life of the student to cover the debt if tragedy strikes. Given the age of the applicant and the amount of the term insurance required, this typically is an inexpensive solution. Conversely, if the student’s co-signer dies or files for bankruptcy himself, private student loans have an “auto-default” provision, giving the lender the right to demand full payment. If the loan is not repaid, it is declared to be in default, which inflicts serious damage to the student’s credit record. The strapped student has zero recourse here other than to pay off the loan with another loan.

We recommend, as much as possible, if not in all situations, just say no to co-signing. The risks involved are simply too dangerous to your own financial health.

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