Wednesday, April 6, 2011

NEVER co-sign a Loan!

Never EVER co-sign a loan!  It could bankrupt you!

UPDATE:  April, 2012.  After reading this article, if you are still not convinced that co-signing a loan is a really bad thing (and people who ask you to do it are evil) read this article.  Every major financial adviser says to never, ever, ever, EVER do this - and for good reason!

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In my "Never Buy A Condo!" article, I noted that the title was a bit tongue-in-cheek, as there can be situations where buying a Condo might be worthwhile, if you are careful and have realistic expectations.

However in this instance, when I say NEVER, I mean NEVER, period.  I am not being dramatic with the title here. Co-signing a loan is one of the worst financial mistakes you can make. Many people who get conned into doing this end up spending years repairing their credit and finances.

1. What does Co-Signing Mean?

If you apply for a loan and have bad credit or no credit, or are underage, the loan officer might suggest that you get a co-signer to the loan, if you do not qualify by yourself. Typically,this occurs with car loans, and typically, a parent, relative, or friend is approached to be a "co-signer" on the note.

Usually, most respectable banks and lending institutions won't suggest this step. However, the E-Z Money finance places are quick to make such suggestions, which speaks volumes as to the nature of co-signing. Co-signing of loans is more prevalent in the poorer sections of our society. Smart people don't get involved in this sort of thing.

To some folks, co-signing seems like a mere formality - you get another "name" on the loan just for formal purposes. When my partner was a manager of a food store, employees would regularly approach him, asking him to co-sign their loans for him, as if it were a mere act of notarization.

But, as we shall see, it is not. By co-signing a loan, you are liable for the full amount of the loan. In essence you are borrowing the money, since the person signing is not qualified to borrow it.

2. Why is it a Bad Thing?

The problem with co-signing is that you are wholly liable on the note, but have little or no control over the situation. If you co-sign on a child's car loan, the loan payment notices go to the child, and the child is responsible for making payments on the loan. If they are late paying on the loan, chances are you'll never know about it until the loan goes into default. At that time, you'll be contacted to make the payments, but by then, your credit rating is already dinged by the late payments on the loan.

So you end up at-risk, with no control over the process.

3. You are Liable for the Entire Loan Amount

This seems pretty simple, doesn't it? You are liable for the entire loan amount. If the borrower doesn't pay, you have to. If you don't pay, you can be sued for the balance on the loan and your credit rating destroyed.

Meanwhile, the borrower has a new car to drive around. Sweet deal for them, no? Unless you are prepared to buy your friend or child a new car, don't co-sign the loan.

4. It Dings Your Credit, Even If the Borrower Pays

If you co-sign a note, it appears on your credit report as a liability. So your available credit drops accordingly, along with your credit score. Even assuming your deadbeat friend makes the payments (and they are a deadbeat, the bank said so by refusing the loan in the first place!) your credit is affected.

Suppose the next year you decide that YOU want to buy a car? But now you find out, to your dismay, that you don't have the credit to get one, as you are "maxed out" by co-signing someone Else's loan. Like I said, NEVER co-sign a loan!

5. But My Child/Friend Won't Default!

Guess again. As we learned during the recent banking meltdown, there were sound and solid reasons why we had strict loan guidelines over the years for mortgages. People who put nothing down are more likely to "walk away" from a home that drops in value and are less likely to be able to make the payments.

When a bank turns someone down for a loan, it is because they don't think they are likely to pay it back. People miss this simple point, often thinking bankers are being "mean" or "unreasonable" by denying a loan application.

On the contrary, being turned down for a loan is sometimes the best thing a bank can do for you, as they are telling you that you need to get your financial house in order. Loaning money to you on onerous terms that will later bankrupt you is not doing you any "favors," but there is an industry of lenders out there willing to do just that.

Thus, if a bank turns down a friend for a car loan, and they come to you to "co-sign" the loan, you should turn them down, too. Why? Because people much smarter than you have already determined that your friend is a poor credit risk. If your friend pushes the matter, be sure to point this out to them - if the bank thinks they can't pay it back, maybe they should listen to the sound advice from the bank.

And if a friend pushes you to sign, threatening to end the friendship, then they are no friend to begin with. Chances are, the friendship will die as a result of co-signing anyway, as it all goes horribly wrong, and you end up buying them a car (and they tell everyone what an asshole you are for insisting on being paid back). Just cut to the chase and end the friendship now. You don't need white trash friends like that, anyway.

6. Most Co-Signers End Up Making Payments

The banks have it right. The person needing a co-signer usually cannot make the payments on the loan. As the co-signer, you should expect to make at least some payments on the loan, if not having to pay off the loan entirely.

Thus, if you co-sign a loan, there is a pretty even chance you will end up paying off some or all of the note. Since your friend who didn't make payments can't make the payments, chances are, they won't be able to pay you back as well. Once they fall behind on payments, they will continue to fall behind. They never "catch up".

And guess what? Chances are, you can't make them pay you back. By co-signing the loan note, you generally do not have legal rights to go after your friend for the missing payments or to take back the car. They own the car you paid off, free and clear. The loan papers do not give you any rights to go after your friend. Even if you could get some sort of agreement in writing, enforcing it would be expensive and difficult.

And of course, verbal promises from your friend to "pay you back" are largely unenforceable. And of course, they never pay you back.

7. So Why Do People Do It?

Because people are idiots, period. As I have noted before, people fall for all sorts of scams, rip-offs, or just plain bad deals. And often, many people fall into these bad deals because they think "well everyone does it, so it can't be that bad".

But like gambling, or rent-to-own furniture, just because a lot of people do it, doesn't mean it is a good deal. And in fact, those are horrible deals. And co-signing a loan is a terrifically horrible deal.

Many parents co-sign loans for their children to buy new cars, and this is a big mistake for many reasons. First, the parents will likely end up making payments on the car. Second, spoiling a child with a brand-new car is just wasteful. Third, until you turn 25, the insurance rates on cars are horrendous, so it makes no sense for a child to own a car that requires collision insurance. Many young people pay more per year for car insurance than they do for car payments. Fourth, when it all goes horribly wrong, the parents end up in debt and with a bad credit rating, and they themselves cannot afford to buy a new car.

And that is another irony of the situation. Many parents co-sign loans thinking they are "helping the child establish credit." But a co-signed loan might not really establish independent credit if paid off. And since it is more likely to go delinquent, it ends up ruining the child's credit rating, defeating the purpose of the exercise.

Another situation, as noted above, is when some naive person is snookered into co-signing a loan for a friend or acquaintance. As I noted, my partner, as boss at a retail store, was besieged by employees who wanted him to co-sign a loan document. Some people are so unsophisticated that they don't realize what they are signing. And not knowing what you are getting into is no defense down the road.

So yes, people do co-sign loans all the time. But people also jump off bridges all the time. That doesn't mean it is a keen idea. In fact, getting out of the mindset that "well, everyone does it" with regard to any financial situation is probably a good idea. 70% of all credit card holders carry a balance and pay interest every month. That doesn't make it a swell idea.

8. Nightmare Scenario

Susie and Betty were best friends since High School. They shared an apartment together and both had steady, if not high-paying jobs. Betty comes back to the apartment one day, bubbling over about a red compact car she saw on the dealer lot. Betty wanted to buy the car, but the salesman said her credit wasn't sufficient. If she could find a co-signer, she could get the loan.

Now Susie had a good credit rating. She worked part-time jobs in High School and learned how to save money. She had a department store credit card and paid it off every month. And she had a VISA card that she also paid off every month. She had good credit for a young person.

Susie was skeptical at first, but Betty convinced her to sign. "Come on, you know I need a car to get to work!" Betty said, "and that old clunker of mine is on its last legs! They just need another name on the loan to show I'm good for it!"

Not realizing what she was signing, Susie co-signed the loan papers and Betty came home with the sporty red compact the next day, complete with temp tags. For the first week, it was a lot of fun. Susie and Betty would go out driving and go to bars, with Betty showing off her new car. But things started going downhill rapidly.

Insurance on the car wasn't cheap, although insurance for young women is less than for young men. But Betty had a "lead foot" and got a couple of speeding tickets in quick succession. The insurance company quickly raised her rates, and suddenly she was paying more in insurance for the car than the monthly car payments.

Within a year, the aura of newness had worn off the car, mostly because Betty didn't take care of it and left it parked outside. And frankly, it was not much of a car to begin with. While it looked new and sporty in the showroom, the reality was, it was an econobox car that was not very well made.

Susie thought about getting a car of her own and went down to the same dealer. She found a similar car, and she and Betty thought it would be a hoot if they had matching cars, Betty's in red and Susie's in blue. But the salesman had bad news. Susie couldn't qualify for the car loan, as her credit was insufficient. The salesman showed her the credit report - listing Betty's car loan. Susie was shocked to see that it showed several payments over 30 days late, and the current payment unpaid for 60 days. Betty never told her about this!

"Well how about if Betty co-signs my loan?" Susie said. The salesman just snickered. Betty's signature was worth nothing at this point.

They returned to the apartment depressed, and Susie started to get a glimmering of what was to come. Only four more years left on the loan, she thought, and then maybe I can buy a car, too.

Betty's driving (and drinking) habits did not improve. She got another ticket, and then got into an accident. By this point, the insurance was so expensive that Betty had stopped paying it. Her insurance had lapsed by the time of the accident. The car was totaled, and the insurance company refused to pay off the loan.

Worse yet, Betty got a DUI in the accident and spent time in jail. She was spending every last penny on her legal defense, and had long ago stopped making payments on the now-totaled red compact. Betty borrowed Susie's car for her court appearances.

Susie got a letter from the bank stating that she had to make the payments on the car loan, which was now in arrears and the entire balance was due. This lead to a heated argument with Betty, a shouting match, and finally bitter recrimination. Betty moved out of the apartment and back in with her parents. The friendship was destroyed forever.

Living alone in the apartment was more money than Susie could afford. Adding in the cost of the car payments for the nonexistent car, Susie was in dire financial straits. She could make the payments for another four years, try to borrow the money from her parents, or declare bankruptcy. Her parents didn't have the money. Susie filed for Chapter 13 bankruptcy.

While Bankruptcy did discharge the debt to the loan company, Susie found it was much harder for her now. Job applications all asked if she had ever filed for bankruptcy, and this made it harder to find a job, particularly in accounting related fields, where she hoped to build a career. It would be years before the incident was wiped off her credit record. In the meantime, if she wanted credit, she could obtain it on only the most onerous terms - often 20% or more.

When she told her tale of woe to friends and acquaintances, she was not met with sympathy. Most chastised her for being so stupid. Others edged away, not wanting to be close to someone so irresponsible, and fearful that Susie would start asking them for money. Eventually, Susie realized that it was best not to mention her plight, and she kept it to herself.

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NEVER co-sign a loan, period. If you do, your credit will suffer because of the outstanding debt. It will suffer further when the primary borrower is late on one or more payments. It will suffer further when they default on the loan. You'll end up on the hook for the full loan amount, and end up buying someone else a new car - while depriving yourself of one at the same time.

It is not simply a matter of "doing someone a favor". Co-signing a loan causes real damage to your finances. Just don't do it!

A friend of mine just co-signed someone's mortgage.  If that person defaults, my friend has to make their mortgage payments for them - or end up in bankruptcy court.  But they can't force the friend to pay up - or even sell the home.  They are stuck, period, paying someone Else's mortgage for live.  What's not to like?