“Co-Signing a Loan? Beware!”

I can think of lots of reasons you might want to help out a family member or friend by co-signing on a loan for their behalf.  For a child, it might be a car loan, bank loan, credit card application, student loan or home mortgage.  For a friend, it might be a loan to consolidate debt, help solve a short-term cash flow problem or a loan related to a business.  Whatever the reason, you need to approach the topic with your eyes wide open.  Here are a few of the major potential pitfalls for you as a co-signer:

  • High risk lending. First, be clear that if the borrower cannot get a conventional loan through a bank, mortgage company, auto lender or credit card company, they have been judged to be a sub-standard risk; meaning professional lenders have determined they are much more likely to default.  In my experience, main-stream lenders are pretty good at assessing risk and if they are unwilling to make a loan, you should be very cautious as well.  The bottom line is: If the borrower doesn’t pay, you’ll be responsible for satisfying the debt.
  • Your relationship is on the line. For me, this may be your biggest risk.  Lending money to someone you know and care about almost always changes the nature of the relationship.  In some cases, it’s only slightly while in others it is significant.  This is always the case if there is a default.  I’m not certain how to articulate how or why this is but it is true.  Maybe it’s the shift to the subservient nature of the lender/borrower particularly between two people who already have a relationship.
  • It could impact your credit. Depending on how the lender reports to the credit bureaus, the payment history may show upon your credit history.  A history of late payments or default could have a negative impact on your credit score.
  • Your ability to borrow could be restricted. If you are attempting to get your own loan, the fact that you are a co-signer could make it more difficult.  Particularly for bank loans, you’ll be required to submit a sworn financial statement that list all of your assets and liabilities.  While the co-signed loan is not your direct liability, it is a ‘contingent’ liability and the bank will take into account that it could end up being your direct liability.  For example, you co-sign on a $250,000 mortgage for your child, you’ll need to list that as a contingent liability on the financial statement you submit to the bank.  Co-signing a loan can also show up in your credit history which lenders review prior to granting you a loan.  The amount of the co-signed loan will affect your debt ratio which is one of the key metrics lenders use to evaluate loan approvals.
  • Potential tax consequences. Even if a lender writes off a loan as uncollectible, you could be hit with an income tax liability.  For example, in the aftermath of the 2008 Great Recession, I was involved in a case where a group of real estate investors had their loan abruptly ‘called due’ by the bank (even though all payments had been made on time).  Some of the investors did not have the funds to pay off their share and settled with the bank for less than the loan amount.  Each of those investors received a Form 1099-A for reportable income for the difference between what they paid and what they owed.  It’s what I call ‘phantom income’ because you receive an income tax bill but no cash.

While there are certainly circumstances where co-signing a loan is appropriate, my general rule is to avoid them.