Let’s say you were approached by your friend Stacy who needs help qualifying for a mortgage to buy a home. She asks if you’d be interested in co signing a loan for her. You generally trust Jane and think she’s pretty responsible. But you’re concerned about being on the hook for that money. Keep in mind that if you co sign a loan, the lender can come after you before going after Stacy and most likely will if Stacy doesn’t pay.
Studies by the IRS show that once a loan is in default, the co signers are forced to pay in 3 out of 4 cases. How do you protect yourself?
This is a very good question because once you co-sign a loan, the debt is yours regardless of what you and Stacy agree on. Here are 5 tips to protect yourself if you decide to co-sign a loan:
1. The Talk
Before doing anything, set the stage so Stacy has the right mind set. Explain to Stacy that you are willing to help her but you need security. Tell her that circumstances may occur that are beyond her control that nobody expects. If that happens, and she’s unable to make the payments, you’ll have to make those payments. As a result you’ll need to take some extra precautions in order to make sure you can make those payments without putting your own financial situation in jeopardy.
Remind her that you’re basically taking responsibility for the debt because without co signing the loan, lenders won’t lend her money. The reason they won’t is because she doesn’t have the credit score to buy a house. They think she has a high probability of default.
Explain how her default would impact your financial situation. As a result, you need extra security. This step is the most important of all if you want to protect yourself, maintain your relationship and co sign the loan. Don’t wait to have the talk until there is a problem.
Make sure you can afford to make the payments if you have to take them over. Know the principal balance and the monthly payments. Look at your budget and make sure you can afford to make those payments if you have to.
Since your name is on the debt, make sure you get monthly statements. The last thing you want is to get a letter demanding interest and penalties because Stacy failed to make payments for the last 3 months.
This may sound really harsh, but unless you’re willing to pay off the debt and call it a gift to Stacy, you need collateral. Get her to transfer some other asset or investment to you for the term of the loan she is taking. Also, make sure you buy term life insurance on Stacy but have her pay the premiums. You must be the owner of the policy to make sure the premiums get paid. Being nice is one thing. Putting your financial security at risk and suffering huge investment losses is quite another.
5. Make Them A Better Offer
Once you lay out all your requirements, Stacy may look for some other sucker…ooops…I mean friend to co sign the loan. If that doesn’t happen, make her a different proposition. Suggest that you buy the asset (if you can afford it) and rent it to her. Her rent would equal the loan payments and once they are paid off, you’ll sign the property over to her. The beautiful thing about this approach is that you don’t take on any risks or complications. If Stacy does what she says she’s going to do, nobody gets hurt. If she doesn’t, you take possession of the asset and sell it. If you go this route, make sure you get a big enough down payment from Stacy to cover your risk of depreciation.
Have you ever been involved in co signing a loan? How did it work out?