The deadline for fall tuition bills is coming up and if you’ve maxed out the federal financial aid you are eligible for, you might be thinking of going to a private lender to borrow money.
For a young person with little credit history or low to no income, getting a private loan will likely require a co-signer. Underwriting standards have become much more strict since 2008 when the recession hit and student loan default rates spiked. About 94 percent of undergraduate student loans for the 2015-16 academic year included a co-signer, up from 76 percent in 2008, according to MeasureOne, a data and analytics company that specializes in student loans.
The vast majority of co-signers are parent or close relatives, though anyone can co-sign a loan as long as they meet the credit requirements. Having a co-signer improves your chances of approval. Both the borrower and co-signer’s credit histories are evaluated, so you could get a more favorable interest rate too.
But that puts parents and relatives in a tough spot since guaranteeing someone else’s loan carries major risks. “People get lulled into a false sense of security when they co-sign,” says Heather Jarvis, a lawyer who specializes in student loans. “Signing your name to the loan is the same as taking the loan out yourself.” That means the loan will show up on your credit report. And if the borrower doesn’t make payments, you are equally responsible for it or your credit score takes a direct hit. A loan can go into default for even one missed payment, says Jarvis. If that happens, the entire loan comes due.
If you are considering co-signing a student loan for someone, here's what you should do before putting yourself on the hook for someone else's college costs.
1. Exhaust Federal Options
Before you turn to a private loan, make sure the student has applied for all the federal aid he or she is eligible for: Scholarships, grants, work-study and federally backed loans. Federal loans don’t require a co-signer and come with consumer protections such as the ability to defer or stretch out payments if you have trouble paying. But there are limits to federal loans. You can borrow roughly $5,500 to $7,500 a year depending on what year you are in school but no more than $31,000 in total for undergraduates.
If that’s still not enough to cover the total cost of attendance, a parent or guardian of the student can take out a Parent PLUS loan to cover the gap. A PLUS loan is solely in the parents’ name, not the student's name. But Parent PLUS loans have more flexible repayment options than private loans and require only a basic credit check. “Federal student loans are much less risky and a much better option for parents,” says Jarvis.
2. Don’t Let Low Rates Fool You
Federal student loans and Parent PLUS loans have fixed interest rates, so the monthly payment is predictable. Private student loans typically have variable interest rates that may be below the rate government loans charge because of today's low-interest rate environment. But variable rates can rise and since student loans have terms of 10 or more years, the monthly payments and the total amount you owe could become significantly bigger. Some banks do offer fixed-rate loans, so if you do opt for a private loan, look for those as well.
Many private loans also require payment while the student is in school. Federal loans have a grace period so loan repayment doesn't kick in until six months after graduation.
If you do go with a private loan, don't just apply to bank lenders. Credit unions and states also offer student loan programs. “There’s no guarantee that those will be the best but as with any loan, you should shop around,” says Betsy Mayotte, the director of consumer outreach and compliance at American Student Assistance, a nonprofit that provides education programs for student loan borrowers.
3. Understand the Terms
Read the entire promissory note you must sign to get the loan. Make sure you understand what circumstances trigger a default and whether there is any flexibility in payments. Check if the loan comes with a death or disability discharge. More lenders are offering those clauses, says Mayotte, but if that clause is not available, the co-signer is responsible for payments if the borrower dies or becomes disabled and can’t pay.
4. Get a Co-Signer Release
Some loans come with a co-signer release provision. After a number of on-time payments—typically two years—or when the primary borrower achieves a specific credit score, you might be able to remove your name from the loan.
This form can also protect the primary borrower. If the co-signer dies or files for bankruptcy, the loan is immediately put into default and has to be repaid in full. But the release doesn’t kick in automatically. You have to keep track of the on-time payments and request the release when the requirements are met.
The release can be tough to get. According to the Consumer Financial Protection Bureau, less than 10 percent of borrowers who apply for a cosigner release succeed. You can increase your chances by doing things such as signing up for automatic payments to ensure you're never late and applying only after your monthly payment drops to 10 percent or less of your monthly gross income to show you can comfortably make payments, says Mark Kantrotwitz, publisher of Cappex.com, a website that provides advice on college planning and finding scholarships. Another option: If you can refinance your private loans with another lender, the co-signer will be released.
5. Check Out the Student's Finances
Co-signers should protect themselves by understanding the primary borrower's financial situation. Calculate the monthly payment and how much the total cost of the loan will be with interest. Can the student handle the monthly payments if he has to start payments in school? What kind of income do you expect him to earn when he graduates? If you do co-sign, you'll also need to keep track of the loan and ensure that payment obligations are being met. If you don’t know that the primary borrower is falling behind, penalties and fees will get tacked onto the loan.
If you’re uncomfortable co-signing, don’t do it. If a student needs a co-signor, it could be that the student is borrowing more than he or she can afford. Consider other options. One idea is to loan the student money and get paid back in installments. Another idea: The student could lower costs by living at home. Or, perhaps an installment plan to pay tuition would make the payments easier to handle.
“I worry about families who take on private debt," says Mayotte. "There are very few options if you have trouble paying the loan.”
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