What You Need to Know Before Co-Signing a Loan

Your daughter just graduated from college and got her first job. She’s on her way—but that old car just won’t make it to and from work reliably. You go to the car dealership with her, pick out a modest, affordable and safe new ride, but the finance manager tells her she hasn’t been in her job long enough and/or doesn’t have enough credit history to qualify for a loan. The manager turns to you, and says, “Mom, Dad: Will you co-sign the loan for her? If you do, she can drive that car home today.”

Before you sign on that dotted line, it’s important to understand that you are just as responsible for paying the monthly loan payment as she is, and if she doesn’t make the payments, you are on the hook.

Your Responsibilities

Every potential co-signer is given a notice to read before agreeing to sign on a loan, and the responsibilities are clearly spelled out. This co-signer’s notice warns you that you are guaranteeing the debt that the borrower is about to take on and advises that you will be required to pay the debt if it isn’t paid—up to the full amount. The lender can also come straight to the co-signer (you) and bypass the borrower.

What all of this means is that if the loan is at risk of going into default, you might have to dip into your savings, tap into a line of credit, or refinance the loan to pay it yourself rather than face the potential consequences. Read on to learn about more risks of co-signing a loan.

Effect on Your Credit Score

Your creditworthiness to lenders is based, in large part, on your credit score. The higher your credit score, the lower your interest rate. Look at the difference 1 percentage point of interest can make:

Let’s say you take out a 30-year home mortgage loan in the amount of $250,000 and you qualify for an interest rate of 4.25 percent based on your strong credit score. If it isn’t as strong, you might only qualify for a rate of 5.25 percent. The difference to your pocket? The borrower with the stronger credit score will pay nearly $55,000 less in interest over the life of the loan.

Even if all payments are made on time, your credit score could still be impacted negatively. If you co-sign a $20,000 loan for a car, for example, a financial institution could decline your loan application for your own car if they think you are overextended financially.

Tip: Before you co-sign for a loan, think about the full amount of money you may be out. Will co-signing impact your ability to secure a loan of your own? Or will your loan rate suffer? If so, co-signing may not be in your best interest. Also, do not ignore letters or calls from debt collectors. Call your co-signee at once to discuss the matter and see how you can help to get the payments back on track. If the account goes to collections, your credit score will be affected.

The Cost of Debt Forgiveness

If a loan lingers unpaid, a lender might offer to settle the debt for less than what is owed to wipe the loan off the books. You receive a letter stating that the lender will accept $7,500 to close the loan, as opposed to the full amount of $11,000. That sounds attractive, doesn’t it?

If you are convinced the borrower can’t pay off the balance of the loan, you may decide to pay the offered $7,500 settlement and think you’re done with it. Until you get a form the following January that indicates that the $3,500 you didn’t pay is income. Yes, the Internal Revenue Service considers “debt forgiveness” to be income, and, under most circumstances, both you and the borrower will receive a Form 1099-C that reflects the amount of forgiven debt.

One of you will need to pay income taxes on the forgiven debt, and that is the primary borrower, not the co-signer, under IRS rules. But that doesn’t mean this form doesn’t present a hiccup for you come tax time. You or your accountant will need to prepare documentation for the IRS listing who reported the debt forgiveness as income. Be as specific as possible and include the name, address and Social Security number of the borrower who has claimed the income.

Tip: Remember that taking an offer of debt forgiveness will cause more paperwork come tax time. It will also show up negatively on your credit report and impact your credit score.

Judgments and Lawsuits

If the company that doesn’t get its money decides to sue, you could be the person sued. Why? Because your signature enabled the closure of the loan deal. Remember that the notice you were given when you co-signed the loan states the creditor can try to collect the debt from you without trying to collect it from the borrower, if your state law allows that.

If the lender wins in court, a judgment will be entered against you, which could lead to an order to garnish your wages.

If you’re unaware that payments haven’t been made, you’ll find out when the debt collectors start to call or send letters.

Tip: It is worth monitoring your credit report monthly to make sure the loan payments are being made so that you can act before you get to this stage.

When you’re sitting in the finance office at the car dealership with your daughter, it’s easy to agree on the spot to co-signing the loan. But think about the implications and discuss the significance of the action you are taking with her. Remember that you are 100 percent on the hook for this loan, so you should use extreme caution before signing, and make sure your daughter also understands what is being asked of you.