Cosigning a loan is bad news. I didn’t want to bury the lead in this article because it is something that people need to not only hear, but also understand the financial philosophy as to why it is a really bad idea to cosign a loan. No matter who it is for.
In simple terms, those who need a cosigner are in a position where their credit is either unestablished or too poor to qualify for a loan. In order to qualify for the loan, they need a backer, if you will, who has better than average credit to take responsibility for the payments if the original borrower is unable to fulfill the loan requirements.
Basically, you are asking someone to take a huge risk in volunteering to pay for something that you want, if you are unable to make the payments. As of this writing, I am still developing a full philosophy on building credit and if or how one should do that, but I am of the firm belief that debt isn’t always needed to make one’s life go well.
Cosigning is pretty much telling someone that you don’t have the income or credit history to qualify for a loan on item, “x”, so you need their help. If you don’t have the income or credit history to qualify for the loan, that should be an indicator that you ought not to buy it.
Instead, we sacrifice patience and delayed gratification for instantaneous purchasing which harbors bad habits in us that hurt our efforts for long-term retirement planning. The reason as to why we don’t do well with retirement should be clear. The solution, however, is much more difficult to explain and execute.
I know many, many family members who have used a cosigner and it doesn’t work out well. Moreover, there are a lot of things that people do not consider when they cosign. Bankrate (Which is a great website for studies, etc.) noted 10 reasons why one shouldn’t cosign. Three of the ten that I think most people do not consider are:
- Tax implications
- Organization of payments
- Debt to income ratio
Taxes are usually a problem unless the debt is settled. If a debt is settled, you have to file the difference on your taxes and a responsible for any taxes incurred on that amount.
Organization of payments is one of those things people think about after they cosign. Your credit is now on the line when you cosign. If Billy misses a payment on his new car, it hits your credit. Now you have to make sure Billy makes his payment on time and 60 months of reminders from you to Billy may put a bit of stress on the relationship.
Debt to income ratio is something I suspect many do not think about. Let’s pay this scenario out. You cosign on a $30,000 vehicle for Billy and then six months later sell your house and want to move up in house. Because of that $30,000 loan that you cosigned for, you cannot afford or qualify for as much of a house as you had wanted. Your debt to income ratio is too high and you will not be able to qualify for the amount you want until that $30,000 is off your record.
Friends, don’t cosign. I don’t care if Billy is a “good kid” who has a decent income or not. Cosigning is the banks way of saying, we know this guy (or gal) won’t pay back this loan, so let’s get someone else on the contract we can go after when he defaults. This goes for student loans, laptops, credit cards, and especially homes. You do not want an additional $150,000 mortgage on your credit report; talk about liability!
If you have gotten into a situation where you have cosigned, we can walk you through the steps of getting out of it (if possible) and also manage the debt if it has fallen to you. This seems possible since 75% of all notes with a cosigner end up getting paid by the cosigner, not the original borrower.
That, my friends, is why I never recommend cosigning and I will never do it for anyone, even my kids.