Co-Signing or Co-Borrowing is Serious Business
You can do a good deed by agreeing to co-sign a loan or become a co-borrower on a loan, perhaps to help out someone who doesn’t have established credit or who doesn’t have credit good enough to get a student loan, auto loan, or mortgage on their own. But co-signing or co-borrowing a serious loan is serious business. You could incur liability and risks, and could suffer serious financial consequences even if you know and trust the person who’s taking out the loan.
Many young borrowers have little or no credit history upon which lenders can base a decision for a student loan or a mortgage. Lenders generally take a cautious approach to first-time borrowers. Without a credit history to go on, it’s not unusual for them to require a co-signer before they hand over a check.
For home buyers, today’s tougher mortgage lending standards are serious hurdles that first-time buyers face getting approved for a mortgage. Many may not have a high enough credit score (the median in December for FHA purchase loans was 700) or they may not have enough income to meet the minimum debt-to-income ratio (DTI) lenders require (the median DTI in December was 23 percent, including the mortgage). Only about 60.8 percent of mortgage applications to buy a house were approved in November. Adding at co-signer with good income and few debts can help a first-time buyer over the DTI threshold.
In today’s economy, co-signing is more prevalent than ever. About 10 percent of borrowers need a co-signer to qualify for a loan. People are so desperate to find co-signers that some are advertising on Craigslist, probably not a very successful tactic.
The Perils of Co-signing
That’s because co-signers are not just endorsing the borrower’s ability to pay back the loan. They are legally obligated to repay the debt in the event that the borrower defaults, including the entire mortgage balance in the event of a mortgage default. As soon as they become co-signers, the debt will show up on their own credit reports. If the borrower misses a payment, it will damage the co-signer’s credit report.
Most people don’t realize that the loan can affect their own ability to get financing. Since a co-signer is legally obligated to pay the debt if the borrower defaults, the co-signed loan counts just the same as their own loans on a credit report, and is factored into the co-signer’s debt-to-income ratio when they apply for a loan.
Knowing the borrower well and trusting them is not enough. Unanticipated things happen. People lose their jobs, they get sick and they die unexpectedly. There have been more than four million completed foreclosures since the housing bubble burst.
For the first time on record, the delinquency rate on student loans has jumped above the rate for credit cards, car loans, or any other kind of consumer loan. Some 11 percent of the $956 billion in outstanding student loans are delinquent. Many of those loans will default, with stunningly harsh consequences. Again, millions of co-signers will end up holding the bag.
One of the biggest disadvantages to co-signing a loan can be the effect it has on a cherished relationship with a family member or close friend. Instead being a loving gesture of good will, a loan that goes bad can ruin valued relationships. Nagging, threats, and confrontations escalate to resentments and estrangement should the loan go into default. Getting stuck with the bill can cause an irreparable breach and damage your own financial security. Credit counselors report that co-signers end up with debts they didn’t know they were going to have that strain family relationships, but the debts still have to be repaid.
Think about it this way. When you’re asked to co-sign a loan, you’re being asked to take a risk that a professional lender has decided not to take. Should the borrower become delinquent in making payments on the loan, the lender doesn’t have to exhaust every possible means to get the money from the borrower before he comes after you. The bank or creditor can select which debtor he wants to pursue and he’ll pick the one who is the most likely to pay the quickest.
Co-borrower vs. Co-signer
In some ways, being a co-borrower is a better deal than being a co-signer. Co-borrowers get more benefits for basically the same degree of risk.
First of all, co-borrowers do more to help the primary borrower than co-signers. A co-borrower’s credit history, income and assets are considered together with a primary borrower to qualify for a loan. Instead of qualifying individually, as co-signers are, the primary and co-borrower are able to combine their income and assets into one in order to meet the lender’s borrowing criteria.
However, credit scores from co-borrowers are not combined when it comes to mortgages purchased by Fannie Mae and Freddie Mac (about half the nation’s mortgages), but are considered separately. Lenders making conventional loans are required to focus on the lower of the two FICO scores. But many mortgages are not purchased by Fannie or Freddie, such as jumbo loans. On these, the lender is likely to put more weight on the credit score of the person with the higher income. For some people, it may be necessary to hold off on a home purchase for a few months to allow the co-borrower with credit issues to clean up his or her report and raise the score.
Second, a co-borrower receives direct benefits from the loan. Co-signing leaves you nothing but debt if the borrowers fail to pay. However, if you are a co-borrower, you would share ownership of the home, the car, or the cash from the loan. Co- borrowers take title to the auto or real property. Co-signers don’t have interest in the property purchased, at least on FHA mortgages.
Should you be in a position of needing a co-signor or co-borrower, consider carefully what you are asking someone to do. Above all, be sure you have the ability to repay the loan and make every payment on time. A lot is at stake, including your future relationship with that person.
Should you be asked to co-sign or co-borrow, understand the risks you are taking and that hard times hit the best of us for no fault of ours. If the person you are helping loses his or her job, by co-signing the loan you are agreeing to pay the balance. If you are not able and willing to do so, perhaps there are other ways you can help out.
Steve Cook is managing editor of Real Estate Economy Watch, which was recognized as one of the two best real estate news sites of 2011 by the National Association of Real Estate Editors. Before he co-founded REEW in 2007, he was vice president of public affairs for the National Association of Realtors. In 2006 and 2007, he was named one of the 100 most influential people in real estate.