Recently I was asked by a family member to cosign a loan to consolidate her out-of-control debt. It wasn't the first time a family member has asked me for a financial favor, and it probably won't be the last. I refused. It wasn't easy -- turning down requests from the people I love is never easy -- but I knew it was the right thing to do.
There are good reasons that friends and family members agree to cosign loans: A parent wants to help out a child by establishing a credit history; an older brother wants to help a younger sibling buy his first car; a friend hopes to give someone a leg up after a divorce.
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But cosigning a loan can be a huge financial blunder. If I cosign a loan, I'm agreeing to guarantee the debt -- and if the borrower can't make the payments, the lender is going to come after me and my assets. After the borrower stops making payments, the cosigner may be required to pay the loan's outstanding balance and accumulated interest, along with any late fees, collection-agency costs, and attorney fees incurred by the lender. The lender would have the right to sue me, file a lien against my home and even garnish my wages if I were unable to repay the loan. Generally lenders are allowed to attempt to recover the debt from the cosigner first, without contacting the borrower, though some states prohibit this practice.
How likely is it that I'd be asked to repay the loan? According to the Federal Trade Commission, some studies show that of cosigned loans that go into default, three out of four cosigners are asked to repay the loan.
Finding myself responsible for a cosigned loan in default can damage my finances in other ways. Late payments or, in a worst-case scenario, a court judgment would be reflected in my credit report, as well as the borrower's. That would damage my credit score, which would have a ripple effect through my financial life. In addition to disqualifying me from the best financing deals, a bad credit score could boost the amount of money I pay on auto and homeowners insurance. (Insurers base premiums in part on your credit history.)
My husband Gerry could also suffer. The damage to my credit score would likely lead to higher finance charges if we applied for credit on a joint account. We don't live in a community-property state, in which all debt obtained during a marriage is considered joint debt. (The nine community-property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. If we did live in one of those states, lenders could go after Gerry to repay a loan I cosigned during our marriage if the borrower and I were unable to pay.)
Cosigning a loan could also limit the amount of money we'd be allowed to borrow -- lenders consider that cosigned debt mine, regardless of the primary borrower. We could be refused for credit if lenders determined we jointly have too much credit.
Parents often make the mistake of cosigning credit cards for their children thinking it will give them a leg up in establishing good credit. Cosigning a credit card is even riskier than cosigning a loan because parents have little control over how much additional credit the card issuer will extend to the child over time. While their hearts are in the right place, parents often end up doing damage to both their children's and their own credit scores because they don't properly educate their children on the dangers of missing payments.
Parents who are trying to help their kids establish good credit should note that credit-scoring company Fair Isaac is changing its scoring formula: A consumer added as an authorized user on someone else's credit card will no longer be able to benefit from the primary cardholder's credit history.
Saying I wouldn't cosign my family member's loan was tougher for me than other requests I've received for financial favors from my family members. This person has always confided in me and sought my advice on family matters and relationships, and I felt a strong urge to be supportive.
I fleetingly considered simply loaning her the money, but Gerry would never agree to it. Gerry's offended when family members ask for financial favors -- he feels strongly that people need to fix their own financial mistakes. "You never asked for help when you were neck-deep in debt," he pointed out the last time a family member asked to borrow money. "Digging yourself out taught you how to manage money." And though Gerry denies it, I'm sure it grates on him that the only family members who ever ask us for financial help are mine.
Unfortunately, my own family history has proven time and again that a financial agreement between loved ones usually ends up damaging the relationship, along with the parties' finances. It's also been my experience that granting one financial favor leads to requests for more -- with resentment on both sides. In addition to all the potential financial pitfalls of cosigning a loan, I could be risking the family bonds I cherish.
To soften my refusing to cosign my family member's loan, I offered to look at her overall financial picture with an eye toward freeing up cash flow and finding other sources of income to help make ends meet. I also volunteered to help her negotiate with creditors to obtain more-manageable terms on her debts. Lenders are sometimes willing to temporarily change the terms -- forgoing a few month's payments or lowering the minimum monthly payment due -- in times of financial hardship. (This is particularly true now of mortgage companies, which are reeling from a record number of foreclosures.)
I also offered to help her use financial-planning software to track her spending to find areas where she can cut back. Finally, I suggested ways she could generate more income. Though she works for a large company, her back-office skills are equally necessary for smaller businesses. Why not take on a second job on nights and weekends until the debt load becomes more manageable?
She thanked me, but politely refused my help. I still feel a twinge of guilt for not cosigning the loan -- I remember well how hard it was to extricate myself from my own financial jam. But in overcoming those difficulties, I learned how to better manage money. I hope that she'll find a way to pull herself out of debt and do the same.