How Does a Co-signer Work?

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A co-signer on a loan has the legal obligation to pay the debt if the primary borrower doesn't. As a co-signer, you're not simply vouching for the borrower's good intentions or character. You're backing the loan with your own financial assets. To co-sign, you typically must be 21 years of age or older with a good credit history and credit score. The lender usually considers your income in approving any loan you co-sign as well

When a Borrower Needs a Co-signer

Borrowers need a co-signer when they have insufficient income or don't have a strong enough credit history to qualify for a loan on their own. Having a co-signer enables the borrower to qualify despite poor or minimal credit history, or to obtain a lower interest rate than he would using his credit history alone.

A borrower may also need a co-signer because of age. By law, a borrower under 21 must show proof of independent income to open a credit card account without a co-signer.

What a Co-signer Promises

If you co-sign a loan, you guarantee complete repayment of the debt. The Federal Trade Commission recommends that you confirm you can afford to pay and are willing to do so before agreeing to co-sign any loan.

Possible Risks

According to the U.S. Consumer Financial Protection Bureau, co-signing can limit your own ability to borrow because the loan appears on your credit report. You don't own the car or house you co-signed for, but you assume significant risk:

  • If the borrower misses a payment, you must make it up to avoid a negative entry on your credit report. 
  • You're legally liable for the entire outstanding balance if the primary borrower defaults, as well as any fees and penalties.
  • The lender can sue you if the borrower stops making payments, even without suing the borrower first. 
  • If you lose in court, the lender can take measures to collect, such as garnishing your wages. 
  • If you settle with the lender for less than the full amount of the loan, you could owe income taxes on the difference.
  • Arguments with the borrower can cause a serious rift in your relationship. 

Getting Free of the Loan

Once you've co-signed, it's extremely difficult to get your name removed from a loan, according to the TransUnion credit bureau. Even divorce doesn't end your obligation if you co-signed for your spouse.

To end your obligation, the borrower must pay off the loan or sign an agreement with the lender to release you. Before a lender agrees to remove a co-signer, it typically requires a specific period of on-time payments, such as one to two years.

Ways to Protect Yourself

According to Dr. Don Taylor of Bankrate.com, a co-signer typically has few rights. For example, it's your responsibility as co-signer to find out whether payments are made on time. The Federal Trade Commission recommends taking steps to protect yourself:

  • Negotiate with the lender before you sign the loan agreement. For example, ask that your liability be limited to the loan principal so you don't have to pay penalties or collection expenses. Get these terms in writing.
  • As part of the loan agreement, require the lender to give you written notification when the other party is late with a payment.
  • Obtain copies of all paperwork relevant to the loan, including the contract and disclosure statement. 
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