One of the questions many clients have for their advisors is how to handle a request that they cosign on a loan or guarantee a lease or other similar transaction. Most often, these questions arise in the context of family relationships where the client is asked for assistance by a younger family member who has more limited resources and experience. In fact, parents often agree to cosign for their children in order to facilitate the purchase of an automobile, rental of an apartment or residence, obtaining a college loan or perhaps even starting a business. These are all normal enterprises and worthy of consideration but parents or other persons asked to act as cosignors or guarantors should think hard and long before making that commitment.
Why should you think twice about cosigning? Well, human nature is a good reason for thinking first before signing. The good feelings engendered by enabling a loved one, friend, business associate or other person to obtain a loan may not have legs. As they say, the road to an unpleasant place is paved with good intentions. Down the road, when it is time for your borrower to service that loan and pay back what has been borrowed, all manner of things could get in the way. Sickness, job loss, a change of heart or other considerations might mean that the borrower won’t or can’t pay. This is not to say that default is inevitable, just that it is possible and something to understand before you sign on the dotted line.
Where does the borrower’s failure to pay leave you? As a starting point, on the hook. A cosignor was necessary for the loan to be made and that was because the lender knew that you, cosigning the loan, had sufficiently good credit to make it likely the lender would be repaid. That lender is unlikely to push too hard on the borrower when the borrower fails to pay; instead they will look to you for repayment. Remember, they would not have made the loan, if at all, on the terms they did based solely on the borrower’s credit history.
What alternatives do you have? Almost certainly, you will have to pay the lender and, since the borrower defaulted, you may have a very hard time recouping any of your contribution from that borrower. It is also unlikely that whatever the money was borrowed for will be made available to you or otherwise soothe you for the loss. You can see how that situation might make for difficulties in the relationship you have had with the borrower prior to the loan, cosigning, and default. Suing the borrower can be done but judgments may be difficult to enforce and collect on in any meaningful way.
In the meantime, your credit is affected in several ways. First, even if there are NO difficulties with the borrower servicing the loan, the existence of that cosigned loan affects the availability of additional credit for you. You might find it harder to obtain favorable terms if, after cosigning for the borrower, you suddenly need to obtain some credit for another purpose. If there is a default by the borrower, that may put a black mark on your credit even if you make good on the default on behalf of that borrower (and yourself). Finally, if you are unable to fully make good on a default, that will affect your credit even more adversely than the borrower’s failures.
As you can see, there are some significant potential risks associated with cosigning on a loan for another person. If you have any doubts at all about the ability and willingness of the borrower to make good on the deal, then cosigning should be out of the question. The potentially high price of being nice won’t set well if there are problems with the borrower. It might help to stay on top of the loan, monitoring the payments, but that might be difficult with the lender or the borrower or both. Of course, there may be a way to purchase (at your cost) insurance against a default by the borrower, but that seems to a tough sell and might only work as part of a business transaction as opposed to the typical cosigned loan.
George Chamberlin & Mentor RIA Consulting ©2018