When someone applies for a loan but lacks the credit, income or collateral for approval, the lender sometimes asks for a co-signer. This person, typically someone with the financial attributes that the primary borrower lacks, adds their name to the loan and assumes responsibility if the borrower doesn’t pay.
Co-signing a loan isn’t always a bad thing. For example, parents often co-sign loans for their children’s first car purchases, which helps the children establish credit and receive a loan for which they wouldn’t otherwise qualify.
That being said, stories abound of people who co-sign loans and later regret it. Co-signing without due diligence can lead to anything from a major headache to total financial ruin. Ask the following questions of the borrower and lender before co-signing a loan.
Are You Co-Signing or Guaranteeing the Loan?
When speaking of loans, many people use the terms “co-sign” and “guarantee” interchangeably, but the two terms have important differences. In most cases, guaranteeing a loan is safer, as the lender must exhaust all avenues of collecting from the primary borrower before going after the guarantor.
Co-signing a loan, in contrast, puts you at equal risk as the primary borrower of having your bank account seized, your paycheck garnished or your credit score trashed if the loan goes into default. The lender may demand payment from either the primary borrower or the co-signer at any time. If the lender feels you’d be easier to collect from than the primary borrower, you could have a headache on your hands in short order.
Can the Lender Seize, Sue or Both?
If the loan involves collateral, the lender’s first recourse for nonpayment is often to seize the collateral and sell it to pay off the loan. Car loans and mortgages are good examples of collateralized loans, with a car repossession or home foreclosure representing lenders’ efforts to seize collateral.
Sometimes, seizing and selling off collateral is insufficient to satisfy the outstanding loan balance. If, for example, the primary borrower owes $20,000 on a car that is worth only $15,000 at the time of repossession, a deficiency balance of $5,000 remains.
As the loan’s co-signer, you might be liable, depending on your province, for any deficiency balance left over after collateral is seized. Some provinces have laws that prevent lenders from suing the borrower or co-signer after seizing collateral.
Why Are You Needed?
Another good question to ask is why the borrower needs a co-signer in the first place. If the borrower is your 18-year-old child, and the child has never had a loan and therefore lacks credit, co-signing may not be a bad thing, especially since you probably still financially support the child in some way.
If, on the other hand, your child is 35 and still can’t get a loan without a co-signer, you should find out why. Does your child has a history of not paying bills? If so, that portends financial trouble in your future if you assume the risk of a loan on your child’s behalf.