6 Reasons to Think Twice About Co-Signing a Loan

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If your credit and finances are in good shape and you have friends or relatives who are not in such a good credit position, you may have been approached to co-sign for a loan or credit card.

While your friend or relative may deserve the help, it’s not always wise to lend a hand to a sagging financial situation. Here are six reasons why you should think twice before you sign on the dotted line for someone.

1. Risk-to-Reward Ratio Doesn’t Favor You

If you co-sign a loan, the liability lies squarely on your shoulders should your friend or relative not make the payments. They may still be enjoying the home or car they got with the loan while you are left holding the bag on the responsibility of paying it off. And, if you don’t…

2. A Lender May Sue You if Payments Are Not Made

“When a cosigned loan goes into default, the creditor can collect against all who are named on the account since they have an equal share of the responsibility to repay the entire balance,” according to Bruce McClary, vice president of communications for the National Foundation for Credit Counseling. “A creditor can make their own decision to pursue the primary borrower or collect from the cosigner. It is common for a lender to make first attempts to contact from the primary before turning attention to the cosigner.”

3. If a Loan Payment Isn’t Made, Your Credit Is Impacted

The co-signed loan will appear on your credit reports, including the payment history — good or bad — for the loan. While the damage late payments can do is mitigated over time, generally, your credit report can be severely impacted for years. You can see how your payment habits are affecting your credit by viewing a snapshot of your credit report, updated every 14 days, on Credit.com.

4. Your Relationship May Suffer

As the old saying goes, “money and friendships don’t mix.” Placing your credit report and therefore credit scores in the hands of another individual can place a strain on a relationship. You may begin to notice other money behaviors that you previously thought were quirky or endearing that now seem alarming. Your feelings about your loved one may change in a negative way.

“It is not uncommon for relationships to end when cosigned loans slip into default, leaving much more than a financial mess,” McClary said. “This can be prevented if people either avoid cosigning altogether or proceed with a plan that accommodates for keeping the lines of communication open during hard times.”

5. You Could Face Tax Consequences

When autos are repossessed, there can sometimes be what is known as a deficiency balance. This is the result of when the lender has repossessed the vehicle, takes it to auction and is not able to recoup the amount still owed by the borrower.  Some lenders will forgive or write off a deficiency balance if it’s obvious the borrower has no assets, but if you’re co-signing for someone, chances are there are enough assets between you and the person you’ve co-signed for that the lender is not going to be as lenient. In that case, the deficiency balance could be turned over to a collection agency that may be willing to cut a deal to accept less money than is owed and will mark the debt as paid in full.

In the case of credit card debt, once a debt goes 90 days delinquent, a bank is usually willing to talk debt settlement.

In cases where the amount forgiven during debt settlement (or the difference between what is owed and what the lender gets for a car at auction) is $600 or more, a lender must issue a Form 1099-C or 1099-A to the borrower (and the co-signer) and the difference must be reported as income on that year’s tax returns. That’s because the difference between what is paid on the debt and what is owed is considered a net income gain by the IRS, and taxes need to be paid on this gain. If your tax bracket is 28% and the amount forgiven is $2,000, you could wind up owing Uncle Sam an additional $560 come April 15.

6. You May Be Turned Down for Other Loans

Even if your friend or relative makes all the payments on time, your borrowing ability will be affected.

“Provided that the creditor reports account activity to the credit bureaus, cosigning a loan will likely mean that the account will show up on the cosigner’s credit report,” McClary said. “This means that it will impact their debt ratio, which influences a lender’s decision about whether they can afford to take on more debt.”

Image: BartekSzewczyk

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Is There a Difference Between a Co-Signer & a Co-Applicant?

The terms “co-signer” and “co-applicant” may sound like they’re the same, but there are actually some key differences between the two that are important to understand if you’re thinking about financing a loan alongside friends or family members.

What’s the Difference?

A co-applicant, also sometimes referred to as a co-borrower “is a full-fledged partner in the account or loan transaction,” Thomas Nitzsche, media relations manager for ClearPoint Credit Counseling Solutions, said in an email. Each person has all the same rights and responsibilities pertaining to the loan and, when it comes to applying for the financing, both parties’ financials, including income, are generally used to calculate how much credit should be extended, he said.

Co-applicants are typically common when it comes time to buy a home.

“For mortgages, this divides the responsibility of repayment equally between the two property owners,” Bruce McClary, vice president of public relations and external affairs at the National Foundation for Credit Counseling, said in an email.

But, no matter what type of financing is involved, both parties are on the hook for any missteps.

“If defaulted, both parties are equally fully responsible even if it was only one of them who ran up the charges (we usually see this with credit card accounts when clients divorce),” Nitzsche said.

Co-signers, on the other hand, are generally added to an account in order to help someone with no credit or bad credit get financing.

“The healthy credit record of the co-signer can help the other person get past credit approval thresholds and qualify for more affordable rates,” McClary said. But, despite that role, a co-signer generally isn’t granted the same usage rights as the primary borrower. (For instance, a co-signer on a mortgage may not have property rights to the home.)

Still, “if the primary applicant fails to repay the account according to the terms of agreement, the lender can [pursue] the co-signer for the remaining balance,” McClary said.

It’s also possible to be a guarantor, someone who “guarantees” a loan for a friend or family member.

“A ‘guarantor’ … is similar to a co-signer except that the guarantor doesn’t become liable until the bank has exhausted all other means of collection from the primary borrower,” Nitzsche said. “With a cosigner, the bank can come after both parties right away for collection.”

Considering a Co?

Remember, in all these instances, you could ultimately be on the hook for payments and charges. Plus, any unpaid bills, defaults, collections accounts, or, if the debt is attached to a mortgage, short sale or foreclosure, will likely appear on your credit report and damage your credit score. That’s why you should always consider all your options very carefully before signing alongside someone on those dotted lines.

And, no matter what route you go, it’s important to keep an eye on your credit so you know how any co-signed or joint accounts may be affecting your credit. (You can view two of your credit scores for free each month on Credit.com.)

If a co-signed or joint account has tanked your credit, you may be able to improve your score by disputing errors on your credit report, paying down high credit card balances and limiting new credit inquiries until your score rebounds.

More on Credit Reports & Credit Scores:

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