As you accumulate assets and become more financially stable in your 30s, you'll find yourself in a considerable position that makes you suitable to acquire financial credit. You might have even taken out some loans in the past and paid them back. And now, your credit history makes moneylenders consider you reliable and are open to loaning you more.
But just as creditors note your reliability, so will people around you. Friends, relatives, and close associates will soon start asking you to cosign a loan for them. And to help them out, you might understandably consider it. But should you?
Cosigning a loan can be a great tool for helping someone close to you out of a tight financial fix; nonetheless, it's not a decision you should make lightly. You need to understand all the financial risks of attaching your name to someone's debt.
This article will explore what cosigning a loan entails, the financial dangers that come with it, and what you should consider before signing the loan papers.
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Cosigning a loan means taking responsibility for someone's debt by guaranteeing the creditor you will assume liability if the original borrower defaults. This, in turn, gives the lender the right to ask you to service the loan should the person who took the loan fails to honour their obligations.
When done correctly, cosigning a loan can benefit you; for example, it can make your credit history more solid.
Cosigning a loan can expose you to serious financial risks. Here are some that you need to always keep in mind.
When you cosign a loan for anyone, you are not just using your good credit to help them secure a loan. You are putting yourself on the line. You essentially give the creditor a promise that you will settle the entire loan should the original debtor be unable to. This doesn't just include the principal amount; interests, late fees, and any other costs the lender incurred to collect the loans will be transferred to you.
If you cosign on a car loan, for instance, for your workmate, and after a few months, they stop servicing the loan, the creditor will repossess the car and ask you to make all the payments your colleague missed. If you are unable to, they will resale the car.
And if they don't recoup all the money they owed your workmate after reselling, you'll still be on the hook for all the money they've lost. They can come after your assets if you don't meet the obligations or sue you.
When cosigning, most creditors will require you to take 100% responsibility. You won't have the option to cosign on only a percentage you feel comfortable with.
One of the main reasons people will often ask you to cosign on a loan is because they either don't have collateral they can pledge to the lender or lack regular income. So they will need your help to secure a loan, but when you take responsibility for a loan, you put your assets on the line.
Should they default, the creditor will ask you to service the loan and meet all the payments the borrower missed, and when you can't do that, they will repossess the assets you gave as collateral. They can also sue you and force your employer to deduct money from your paycheck to service the loan.
Since the original borrower didn't have enough to secure the loan, creditors often go after the cosigner more vigorously. Before cosigning a loan and putting your asset or income at risk, ensure you can afford to service the loan on your own or stomach the loss of your assets.
Your credit might be affected in various ways when you cosign a loan. Your access to credit might be blocked depending on how much and how long the repayment term is.
Consider cosigning on a ten years loan for your sibling only for you to need a mortgage loan after three years. Lenders will assess your debt-to-income ratio and might deny you a mortgage because you won't be able to service two loans concurrently. This is because the loans you co-sign will be used to calculate your debt levels.
But the worst hit your credit reputation could suffer is if the original borrower defaults and you can’t meet the obligations. Since you are also responsible for the loan, you risk being listed as a defaulter on a credit reference bureau (CRB). This dent might prevent you from securing loans in the future.
Once you have signed the dotted lines and the borrower is given the loan, you are tied together for the entire loan term.
If you fall out or other issues arise, the lender might not agree to get you off the hook. The borrower will either need to put up collateral or prove to the creditor they can service the loan without your help. They can also consolidate and/or refinance their loans to set you free. However, this is often a complicated process.
When cosigning a loan, you should bargain with the lender to include a release clause in the contract that lowers your loss exposure. This clause can allow you to step back after the borrower has proved they're capable of paying back what they borrowed.
When the borrower defaults, the creditor will come after your or file a claim if the loan was insured to minimise loss. But what will you do when the worst happens? When you cosign a loan, there is often no way to protect yourself, and you might be forced to count your losses.
After paying back all the loans you cosign, you might need to go after the borrower. This might prove to be a tedious process that can cost you much more money to collect or repossess any assets they own in a bid to recover your money.
It is crucial that before you cosign on any loan you ask the cosigner to prove they can pay you back when everything goes south.
The people you cosign a loan for are often individuals closest to you. And saying "no" to people close to you when they ask you to cosign a loan might hurt their feelings, but you have to think of how much worse it could get when they default, and you must carry their cross.
You might find yourself constantly having to follow up and ask them to service their loans, which they can misconstrue as harassment. Worst, if they default, you might have to take legal action against them or send auctioneers to repossess anything that can help you recover your money. They will likely not take this lightly, and your relationship might take a hit.
Cosigning a loan is taking on a huge financial burden. Therefore before you agree to it, here are things you should consider.
Borrower Ability to Repay - Why is the borrower being denied a loan without a cosigner? If it is because of poor credit history, you might want to find out if that might happen again. Independently investigate how they plan to repay the loan and only agree when you are convinced beyond doubt.
Your Ability to Repay - You assume 100% responsibility for any loan you cosign. You must be sure that you will be able to repay it if the borrower defaults. This will probably affect your budget, savings, and even lifestyle. If you can't repay, you risk losing your assets when the creditor sues you.
What is the Loan for - What do they intend to use the money for? Will they use it to generate income, put it in aggressive investments, or invest in liabilities? How well they use the funds will define how likely they are to default.
The loan term - How long will it take to repay the loan? Before you cosign a loan, consider your future needs and emergencies. Cosigning on a long-term loan might affect your debt-to-income ratio, preventing you from taking out a loan when needed.
Time - Cosigning a loan requires you to be fully involved in the process from the application stage to the last minute when the final payment is made. You will also need to constantly follow up with the borrower and creditor to ensure the loan is serviced monthly. You should therefore ensure you have the time to spare and handle all this.
Cosigning a loan blindly can expose you to financial risks that can prevent you from achieving your objectives and, worse, get you stuck in debt. Understanding the dangers that this innocent favor you can do for a relative or close friend carries, can prevent you from acting on emotions and end up ruining your finances.
To avoid these risks, always cosign on loans that you are beyond reasonable doubt the borrower will pay back in total, have an exit strategy, try to get a legally binding agreement, and carefully assess all the possible risks you face when you do it. And that includes loss of assets.