Of all the challenges we run in to in life, financial issues are amongst the most common. Whether it’s not having enough money, being trapped in debt, or suffering from a poor credit score (for a variety of reasons), our finances are often a source of stress.
Having weak credit can seriously hold you back. Buying a home, or obtaining funding for a business, becomes much tougher. Even purchasing a car, or renting an apartment, can be quite challenging.
Perhaps you don’t have bad credit. In fact, your credit score is quite high. However, you have a friend or relative with poor credit.
He or she is having trouble obtaining approval for that car loan, or renting a new apartment. These are life necessities, which few of us can do without.
For that reason, he or she asks you to cosign the loan, or apartment rental, for them. What does that mean?
How Being A Cosigner Works
As a cosigner, the lender will first look at your credit score and income. If those numbers are sufficiently high, then they will have you sign onto the loan.
If the primary borrower (the person you’re cosigning the loan or lease for for), fails to pay, you’re responsible for payment on the loan or rental,. In a practical sense, you’re a secondary borrower.
It is natural to want to help other people. Plenty of scientific studies suggest that humans are wired to want to help others, and that helping others in fact benefits us.
However, you should avoid cosigning loans or house / apartment leases for anyone else. Let’s take a look at why.
Cosigning Exposes You To Legal Liability
Think about what happens if you cosign an auto loan. Let’s say that the primary borrower has no trouble making payments on the loan, for the first 6 months.
Everything is going well. The primary borrower is your cousin, and you two practically grew up as close as siblings.
She has faced some financial challenges in the past, and her credit score (which is a 590) has taken a hit over the years. You’re glad you were able to help.
During the 7th month, however, the trouble starts. Your cousin loses her job, and can’t make payments. Money is just too tight. The car is repossessed shortly after.
Let’s say that your cousin had borrowed (and you cosigned for) a loan of $20,000, and put down $3,000 in cash. Let’s also say that a balance of $17,000 is still left, to be paid on the loan.
When a vehicle is repossessed, the lender will typically sell the car at auction. In this instance, let’s assume that the car sells for $14,000, at auction (including auction expenses and other costs). Remember, the remaining loan balance is $17,000.
The $14,000 from the auction is applied to the $17,000 balance. Unfortunately, that still leaves $3000, which was owed on the loan, and has not been paid.
That $3,000 is what we call a deficiency balance. Your cousin now owes the auto lender $3000.
Let’s say the lender sends your cousin a letter, seeking payment of the $3,000. They recieve no response.
After about 8 months, the lender decides to sell the loan to a debt buyer. What’s a debt buyer?
As the name suggests, a debt buyer purchases debts – typically, those which are unpaid, and were written off by the lender. Most of these debts are purchased at a steep discount.
Loan contracts typically state that the loan can be sold – even if the loan is closed, and there’s a past due balance. So, collecting on debt that was sold is perfectly legal.
Debt buyers utilize various strategies to collect on these debts. One approach is to file a lawsuit, usually in state court. If the debt buyer wins the lawsuit, they can often take money out of your paycheck (known as a wage garnishment), or freeze your bank account.
Wait a minute? Isn’t your cousin the one who owes money on the loan (or in this case, to the debt buyer)? Why are you facing the risk of a lawsuit?
Let’s say that the debt buyer tries to collect from your cousin, but she does not respond. Or, maybe she informs them that she can’t pay. The debt buyer investigates a bit more (there are many ways for them to do this), and figures out that she’s telling the truth.
They also know that you cosigned the loan. They look into you a bit more, and figure out that you have a good job, and thus might be able to pay the debt.
The debt buyer decides to sue you in state court. They could name your cousin in the lawsuit as well. However, if they win a judgment, they’ll go after your wages and savings, to pay the judgment.
Remember, your cousin doesn’t have much money. In this situation, your wages and income is what the debt buyer is relying on.
With this judgment in hand, the debt buyer can freeze your bank account, and withdraw money. They can also arrange to take money out of your paycheck. This is known as wage garnishment. There are restrictions on what sorts of funds can be seized from your bank account or wages (and how much). Yet, the fact remains that wage garnishment (and / or a frozen bank account) does put your finances at serious risk, and is a real source of stress.
Having a judgment entered against you creates another challenge. If you try to buy a home, you’ll probably be borrowing through a mortgage lender. Most lenders use databases like LexisNexis to search for public records. In their view, an unpaid judgment poses an additional risk, and could lead to denial of the mortgage.
Cosigning on an apartment lease can pose similar issues. If a tenant whom you cosigned for fails to make payments on a lease, they’ll probably be evicted. Depending on where the tenant lives, you could also be held liable on the lease, and thus dragged into court.
Clearly, cosigning on a loan or lease poses serious legal and financial risks. This is one reason you should be very wary.
Placing Your Credit Score At Risk
Let’s return to the situation we discussed earlier. We’ve already looked at the legal consequences of cosigning, when the primary borrower fails to pay on the loan. Now, let’s take a look at what happens to your credit.
With auto loans, the payment history is typically reported to the 3 major credit bureaus, every single month. In most cases, the loan will appear on both the borrower’s credit reports, as well as yours.
Therefore, as long as the borrower is paying on time, your FICO score (and theirs) will benefit.
However, what happens when the person you cosigned for (the primary borrower) pays late?
Those late payments will appear on your credit report. If you have a strong credit score, a single 30 day late payment can reduce your score by as much as 100 points. If the borrower pays late multiple months in a row, then your score will drop even more.
Of course, if the vehicle is repossessed, your credit will take an even bigger hit. Reducing the damage of bad credit can take years.
Apartment leases operate a bit differently. Monthly payments to a landlord typically don’t show up on a tenant’s credit reports. However, if someone consistently fails to make payments on a lease, they can be evicted.
What’s more, if a tenant breaks a lease early, or damages a property after moving out, they’ll typically be responsible for various charges. These charges can be turned over to a debt collector.
The debt collector will typically report the amounts owed, on both your credit report, as well as that of the tenant you cosigned for. All of this is very disappointing.
You put work into achieving your strong credit score. It was not an overnight event. Rather, it was the product of at least a few years of consistent effort.
Why put your credit at risk, by cosigning for someone else? It just doesn’t make sense.
Damaged Relationships
This is one issue we might not think about as much, but is certainly relevant. If someone does something which harms you, how do you think you’ll feel about them? Think you might be frustrated? It is only natural.
Let’s think about the first example, with your cousin. How would you feel if you cosigned a loan for her, given your close relationship, and it resulted in you being sued, and having your credit score severely reduced?
You did her a favor, and ended up getting burned for it. It’s not unreasonable to be upset.
An important personal relationship has been damaged, because of financial issues. It didn’t have to be this way. True, your cousin might have been upset if you refused to cosign the loan.
However, there were other ways you could help her (more on that below) and preserve your relationship. You’re better off having a frank conversation, and not cosigning.
Alternatives To Cosigning
You now understand why co signing loans and leases is not a good idea. Yet, you want to help. How do you go about doing so?
Helping Someone Improve Their Credit Score
The best thing you can do is empower the person who asked you to cosign, to improve their credit and finances. By doing so, they can enjoy a lifetime of strong credit. As the saying goes, instead of giving them a fish, you’re teaching them how to fish. The first, and most important step, is to understand where their credit score is, and why.
The easiest way to do this is by obtaining free credit reports from Annual Credit Report. Under federal law, you’re entitled to your credit reports, from every single credit reporting agency, once every 12 months. These reports are the most comprehensive source of credit data available to consumers. Have whoever you’re assisting with your credit order these reports.
Next, they should consider signing up for Credit Karma, as well as Experian. Credit Karma provides free Equifax and TransUnion credit reports, updated regularly. It’s an easy to use format.
Keep in mind, however, that Credit Karma provides VantageScore credit scores. VantageScore is a credit score which was created by the three credit bureaus, working together. However, very few lenders actually use Vantage credit score.
They should also sign up for free credit reports from Experian. Remember, there are 3 major consumer reporting agencies, and Credit Karma only offers Equifax and TransUnion credit reports.
Once they have their credit reports, they can gain a better understanding of why their credit scores are weaker than they would like. Perhaps they need to build more credit. Or, maybe they should look into credit repair.
Think about your cousin. Wouldn’t this be a better (more long lasting) way to help her move forward, rather than cosigning her loan? Good credit habits can last a lifetime.
The Final Word
It’s clear that cosigning a loan for someone else, no matter how close they are to you, is rarely a good option. The risks are simply too high.
The good news is that there are many ways to help someone else improve their credit. It is a far better (and longer lasting) gift to give.
