You love your family, your children, grandchildren, nieces and nephews. You do not like to see them struggle or have a difficult time with life. Your parenting/grandparenting instincts kick in and you just want to “help” them out.
It is difficult to say no when your child, grandchild or favorite niece or nephew asks you to cosign or guarantee the loan for their first new car. It is even more difficult when it is a student loan and they are trying to better themselves with an education.
If you have cosigned or guaranteed a loan for a loved one, you are usually told or you may have told yourself that it was not going to cost you anything. They just need you to help them qualify for the loan, for which they are unable to qualify on their own. Your loved ones have assured you that they can pay the loan and they usually honestly believe it themselves. They have every intention of making all of the loan payments and convince you that they can.
But what is the difference between cosigning a loan for someone or just guaranteeing the loan for them? There is a technical legal difference. If you are a cosigner, you are considered a primary borrower with your loved one. You have signed a promise to the lender to pay back the loan. It usually does not matter to the lender which borrower makes the loan payments, so long as they are made.
When you sign as a guarantor of the loan, you are not the primary borrower, your loved one is. You are just guaranteeing to the lender, that if your loved one does not make the payments on the loan, you will.
But there is no real practical difference between cosigning the loan or guaranteeing the loan. Either way, if your loved one does not pay the loan as promised, you do. Whether you are a cosigner or a guarantor, you are on the hook for the entire balance of the loan.
If you are a senior and you are asked to cosign or guarantee a loan for a loved one, you are at a higher risk of making an inappropriate decision than when you were younger. As you age, just like your physical abilities, your financial abilities also decrease with age. It has been shown that after age 60, your financial ability declines about 3% each year, but your confidence in your financial abilities stays the same or slightly increases each year.
So starting at about age 60, there is a generally a growing gap between what you can do with regard to your financial matters and what you think you can do. If you are a senior, you likely believe you can handle your finances as well as you could in your 40’s or 50’s. We regularly see seniors who have cosigned or guaranteed a loan for a loved one, when they never had done so when they were younger.
The cosigners and guarantors usually come to us after their loved one stops paying on the loan and they are asked by the lender to make the payments. They ask us why the lender doesn’t go after their loved one or repossess the car. In most cases the answer is pretty simple, because the lender does not have to. They are going to go after the low hanging fruit, the money that is the easiest to collect. If you are the cosigner or guarantor, that person is you.
You have the resources to pay it off. That is why they wanted you as cosigner or guarantor. You have the 750 or higher credit score, or at least you did before the loan default. Why would they go after your loved one when they are not paying their bills as it is. And repossessing a car is costly and time consuming. They just go after you, who they know has the cash.
With car loans, we typically see the loved one not paying anything and still driving the car, while the cosigner or guarantor has to make all the loan payments. If you want to get paid back, you then have to sue your loved one, get a judgment and then file for a writ to seize the car. Not likely if you want to keep peace in the family.
You may be in for a big surprise when you cosign or guarantee a student loan. What you may not know is that most student loans are federally guaranteed. Generally, Social Security benefits are exempt from garnishment or from the operation of any bankruptcy or insolvency law. However, they are not protected from federally guaranteed student loan defaults. If your loved one defaults on their student loan that you cosigned or guaranteed, the feds can garnish up to 25% of your Social Security. Ouch!
And if you die, your loved ones may be the ones in for a big surprise. Most loan agreements I have reviewed state that the death of the borrower or the guarantor is an event of default that makes the whole loan immediately due. The lender then can just file a claim against your estate or trust to collect the entire remaining unpaid balance.
Sometimes the lender bank requires you as the cosigner or guarantor to open an account with them and keep a minimum balance in that account. If your loved one misses a payment on the loan, the bank does not even need to sue them or you. They just take it out of your account. You have pre-authorized it. Most loan or guarantee agreements I have reviewed have what is called a right of offset. If there is a default, they can just pull the cash from any account that you as the cosigner or guarantor has with that bank.
Wilbur Davidson, the senior partner at the law firm where I started my legal career, used to say that the definition of a cosigner or guarantor is “a fool with a pen in his hand.” When you are asked to cosign or guarantee a loan for a loved one, you are taking a risk that the lender refused to take. The people who lend money for a living have concluded that your loved one would be unable to pay off the loan, so they want someone else on the hook.
If you are asked to cosign or guarantee a loan for a loved one, step back a minute. It may be difficult, but look at it rationally and unemotionally. Are you willing to take a risk that a professional lender wouldn’t? Can you guarantee that your loved one won’t lose their job? Or that they or their family doesn’t get sick and incur substantial medical bills? Or that they will not get into a car wreck and become totally and permanently disabled?
Before you cosign or guarantee a loan for a loved one, here are just a few things to think about:
- Can you afford to pay off the loan if your loved one defaults?
- If you have to pledge some of your own property to secure the loan, can you afford to lose that property?
- Will the loan affect your own credit score or ability to borrow because of your new higher debt to equity or debt service to income ratios?
- Can you limit your liability to the unpaid principal only, but not interest, late charges or collection costs?
- Ask the lender to agree to notify you immediately if your loved one misses a payment or has some other default on the loan.
- You may want to consider putting your name on the title to the vehicle or real estate securing the loan; you have a little more leverage upon a default, but with a little more liability exposure.
If you have already cosigned or guaranteed a loan for a loved one, here are couple of things to do to protect yourself:
- Ask the lender to notify you immediately if your loved one misses a payment or has some other default on the loan.
- Get copies of all pages of all of the signed documents; if any documents were recorded, get copies all pages of the recorded documents. Over the years, we have reviewed hundreds of sets of loan documents and have found that in about 10%-20% of the cases, the unsigned loan documents given to the borrower at closing do not agree with the documents actually signed.
When cosigning a loan, protect yourself. Hope for the best, but plan for the worst. You may be thanking yourself later.
By Matthew M. Wallace, CPA, JD
Published edited April 29, 2018 in The Times Herald newspaper Port Huron, Michigan as: Should you cosign or guarantee that loan?