Before Cosigning a Loan, Know the Risks

Shakespeare probably said it best: "Neither a borrower, nor a lender be, for loan oft loses both itself and friend." Four hundred years later, people still wrestle with whether or not to help out a loved one by loaning them money or cosigning a loan.

Perhaps you want to help your kid qualify for a better student loan rate or assist your widowed mom with refinancing her mortgage. Before you cosign anything, however, make sure you understand the risks involved.

Here are just a few of the things that can go wrong and questions to ask before committing yourself – and your good credit – to what could be a decades-long commitment:

First, understand that the main reason you're being asked to cosign a loan is because lenders don't think the borrower is a good risk. By cosigning, you're guaranteeing that you'll repay the full loan – plus any late fees or collection costs – should the borrower default.

If that doesn't scare you sufficiently, read on:

• Even one late or missed payment can damage your credit.
• In most states, the creditor can – and probably will – go after you for repayment without first trying to collect from the borrower, because they know you're more likely to have the money.
• If the loan goes into default or is charged off, that fact will go into your credit report and can take seven years to erase.
• If you pledged personal property to secure the loan, you could lose these items if the borrower defaults.
• Should the lender agree to settle for a lesser amount, you'll have to report the difference as "debt forgiveness income" and pay tax on it.
• If you cosign a credit card account, primary borrowers over age 21 are allowed to raise the credit limit without notifying you.
• Government-backed student loans generally aren't eligible for bankruptcy protection unless you can prove "undue hardship."
• Some private student loans contain a clause allowing the borrower to originate additional years' loans without your signed approval.
• Even if you're not asked to repay the loan, your potential liability could stop you from getting additional credit if your debt-to-income ratio is too high.

If you do decide to cosign someone's loan, taking these steps can help lessen your risk:

• Calculate whether you can afford the loan's monthly payments, should the borrower stop paying. To be prudent, start setting aside enough money to cover it for one year, which will allow you to keep payments current while working out a solution.
• Insist that the lender agree, in writing, to notify you if the borrower missed a payment or the loan's terms change. That'll give you more time to make contingency plans.
• If you're unsure about the borrower's reliability to pay each month on time, ask the lender to send payment requests directly to you so you can manage the transaction. (It's a pain, but one way to guarantee timely payments.)
• Ask the lender to stipulate in the contract that you're only responsible for the loan's principal amount, should it default. It doesn't hurt to ask.
• Make sure you get copies of all paperwork in case of future disputes.
• Don't consolidate old loans accumulated by your spouse before you married. If something should happen (divorce, death), you would be responsible for paying them off.

There may be times you want to cosign a loan to help out a relative or friend, despite the risks involved. The Federal Trade Commission's "Cosigning a Loan" guide share precautions to take before entering such agreements www.consumer.ftc.gov.)