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Should you ever co-sign a loan?

'New Frugal You' columnist answers one of our 5 most-asked reader questions

By Gary Foreman

Credit Card FAQ

Monday: How do you get debt collectors off your back?
Tuesday: Will canceling a credit card hurt your credit?
Wednesday: You're in debt up to your eyeballs. What should you do next: bankruptcy, debt settlement, credit counseling, credit repair or debt consolidation?
Thursday: Is co-signing a good idea?
Friday:
You've got good credit right now. How can you make it great?

Our columnists are constantly fielding questions from our readers about credit issues. However, over the years, we've seen certain issues pop up more often than others. All this week, we're having each of our columnists field one of the most frequently asked questions for our readers. Today, "New Frugal You" columnist Gary Foreman takes his turn.

Question: Is co-signing a good idea?

We all recognize highway warning signs. They're typically yellow with black block lettering. They all look about the same for a reason. A warning sign is useless if it isn't seen or is ignored. They want you to see the warning signs to avoid danger.

Unfortunately, not all warning signs come with a yellow background and black lettering. Some warnings look different. For instance, when a lender requires a co-signer, that's a warning sign.

The sign is saying that the lender doesn't believe that the borrower will be able to make the payments. The lender wants to make that loan -- that's what they do. But they've looked at the borrower's credit history and concluded that they will not be repaid. So, better to lose the deal than lose their money.

Co-signer will offer assurances
Now that borrower -- be it a child, another loved one or a friend -- is asking you to help them out. You'll no doubt hear plenty of assurances:

  • "It won't cost you anything."
  • "It's just a signature on a piece of paper."
  • "I promise not to miss any payments."
  • "You'll never hear from the lender again."

In short, you're being asked to jump into a car with the borrower, head over to the lender and drive past the warning signs.

What will happen if you co-sign
If you're smart, before you co-sign for anyone, you'll think about what could happen.

First, you're saying that you know the borrower and the borrower's finances better than those who evaluate creditworthiness on a professional basis every day. Even though they're not willing to bet their money on the borrower, you'll bet yours.

Next, you're saying that you're confident that the borrower's source of income will continue until the loan is repaid. There won't be a job loss, a sick leave or a decrease in hours.

You're believing that no other lender will pressure the borrower to repay their loan instead of the one you're co-signing for. Finally, you're also believing that the borrower won't take on some other debt (credit card? health club membership?) that could reduce the borrower's ability to make payments on your co-signed loan.

The New Frugal You
Gary Foreman
Gary Foreman, a former financial planner, answers readers' questions in his weekly The New Frugal You column.

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In short, there are dangerous curves ahead.

What could happen if you co-sign? Even if the borrower makes all the payments, the presence of a co-signed loan on your credit report may prevent you from borrowing money for yourself. As far as other potential lenders are concerned, you're fully responsible for all of that debt and could have to repay it. So it's included in their calculation.

You'll also need to consider what would happen if the borrower does run into trouble with the payments. Much as you may trust the borrower, you need to know that the Federal Trade Commission estimates that the co-signer is asked to make some or all payments in three out of four of all co-signed loans that go into default. 

If you co-sign anyway ...
If you do co-sign, make sure that you can afford to make the payments within your current budget. Insist that the contract include a requirement that the lender notify you if the borrower misses a payment. That will give you an early warning to step in to minimize damage.

Understand that the lender can come after you even before they try to collect from the borrower. You could be responsible for late fees and attorney fees and even have your wages garnished. Plus, your credit score will be negatively affected.

On a personal level, don't be surprised if your friendship with the borrower is negatively affected. It's hard to remain friends with someone who drives a car that you struggle to make payments on.

Finally, recognize that by refusing to co-sign, you're actually doing the borrower a favor. If the lender is right, at best the borrower will struggle to make the payments. At worst, your family member or friend will lose the car -- or whatever was purchased -- damage both of your credit scores and put your once-close relationship in peril.

It's always hard to say "no" to a friend. But, telling someone to ignore a warning sign is not what a real friend does.

See related: Advice for frugal livingDad co-signed, I messed up his credit. Now what?, Mom considers co-signing for daughter's house, Help! My co-signer stopped paying the mortgage!

For more than 35 years, Gary Foreman has worked to help people get the most for their money. Prior to founding The Dollar Stretcher.com, he was a financial planner and purchasing manager. Gary began The Dollar Stretcher website and newsletters in April 1996. Today the website features more than 6,000 articles on different ways to live better for less. Gary has been interviewed by The Wall Street Journal, The Nightly Business Report, USA Today, Reader's Digest and other newspapers and magazines. Gary answers a question about a budgeting or saving issue from a CreditCards.com reader each week. Send your question to The New Frugal You.

Published: August 26, 2010



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