A cosigner is someone who agrees to be liable for a loan if the primary borrower does not pay back the loan. This person decides to become the so-called "lender of last resort" and provides credit support for a borrower for the latter to obtain a loan from a bank or other lender.
Significance of a cosigner
The lenders of last resort typically take on less risk than normal lending institutions, as they are backed by an insurance company or government agency that guarantees repayment if the primary obligor defaults. Unlike banks with significant investment capital, these entities are also not accountable to any shareholders, which means they can have lower interest rates and make loans in times of high demand with greater ease than banks.
Having a cosigner also acts as a form of credit enhancement for the primary obligor, as the lender knows that someone else has invested in and is willing to risk their own money on the ability of the primary borrower to repay the loan if necessary. As such, lenders are more willing to make loans because they know that even if they cannot recoup all of their investment, someone else will be able to pay it off.
In general, co-signing is used when a lender wants to make an exception or change its normal lending criteria for the borrower to consider a loan. For example, a student may need to rent a car for an extended time, but the lender will not typically offer such financing to a student. In this case, the cosigner would agree to pay for any damages the student causes to the vehicle for the loan officer to approve the loan.
Who can be cosigners?
Cosigners are often parents who want their children to have access to credit early and do not trust them with credit cards.
Some online student loan forums recommend that students without credit history consider getting a credit card and making small payments every month to establish a good credit history. Another suggestion is to ask a parent, spouse, or another responsible adult to help the individual establish good credit.
A recent trend in the United States is for parents to co-sign loans for their adult children. This can be due to
(a) the child being unable to qualify on his own; or
(b) the child does not want a loan he cannot pay back himself.
In some cases, such as a home mortgage loan, even though the parents do not plan on having any equity in the property, they are willing to make that investment so their child will have something to call his own.
Benefits of a cosigner
Some lenders offer co-signing as an option for borrowers with good credit who cannot pay in full for the loan at its disbursement. The benefit of co-signing is that it allows individuals to take advantage of lower interest rates and payment terms when securing a loan.
Co-signing has also been used to help parents provide down payments on homes or investment properties by leveraging their tax deductions or retirement cushion. For example, if a family is looking to purchase a primary residence, a parent could buy the home with the child as a living trust beneficiary and reap both state tax benefits and future inheritance without giving away any of their assets. The parent could also gift the child money toward a down payment. However, with a cosigner, the child can still enjoy the equity built up within the home without being responsible for any payments.
Risks of a cosigner
The risks associated with co-signing loans can be significant. For example, if the primary borrower stops paying, it is possible that their income would not be sufficient to repay debts. In addition, if they were underwater on their property (the total loan balance was more than the market value of the house before sale), there would be no assets left to pay creditors.
In some cases, the cosigner would be responsible for paying off the mortgage note or note plus interest if the primary borrower default.
A cosigner failing to repay their obligations to the lender can be particularly devastating for those pursuing higher education or who have obtained a job. Depending on how much of their student debt they have accumulated, college graduates may find themselves unable to pay back even small amounts due on their loans when they start working full time and making regular payments. They lose their chance at repaying the loan in full. Still, any outstanding debt will be taken out of future tax returns, reducing any exemptions they are entitled to under normal circumstances.
Some parents are so devastated when their children cannot pay off student loans that they feel it is their responsibility to repay these debts with their own assets. This can include retirement accounts, life insurance policies, or even the family home sale. Unfortunately, some lenders can attach assets to recoup losses, which means that even assets not initially considered would be subject to seizure by the lender.
One factor that must be considered when a cosigner fails to make payments is whether or not there was a formal agreement between the primary borrower and the cosigner. If there was no agreement in place, then it is possible that the cosigner could be in the clear, depending on state law.
In other words, if a loan was signed simply as an accommodation for a friend and nothing more, then there is a chance that the lender would not seek to collect from the cosigner or other family members.
