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Asked to co-sign a loan? Consider the risks first.

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Leon was very fond of Joey, his 22-year–old grandson.  In fact, his affection for Joey often blinded him to the fact that Joey was not very responsible.  Since high school graduation, Joey bounced between low paying jobs.  Several of his employers fired him for failing to show up for work.  Nevertheless, Leon knew that Joey had a good heart.

One afternoon, Joey came to Leon’s house and told him that he needed a car for a job delivering pizzas.  Joey could not get a car loan on his own since he had very little credit history and virtually no income.  He asked Leon to co-sign on his car loan.  Joey promised Leon that he would make all of the payments.  Joey also told Leon that since the loan would be listed under Joey’s name as the primary borrower, Leon wouldn’t ever have to worry about anything.  

Leon always helped his grandson.  So, he went to the car dealership with Joey and co-signed for Joey’s brand new car.  The bank approved the car loan immediately since Leon’s credit was stellar.

After signing the loan documents, Joey lost the pizza delivery job.  Joey found sporadic work, but no steady employment.

About a year later, Leon received a notice from the bank that the car loan was in default. The notice stated that Joey had not made the payments for the past four months. The bank was demanding full payment of the loan principal from Leon in the amount of $27,000.

Joey admitted to Leon that he stopped paying the car loan.  Joey also told him that he crashed the car.  Worse yet, there was no insurance to pay for the damage.  The car was sitting in a junk yard somewhere.  Joey was unemployed and had no money to pay the bank. When the bank threatened to sue Leon and file a judgment lien against his house, Leon paid the bank in full from his savings.

Co-signing a loan is an extremely risky proposition.  Legally, there is no difference between the primary loan applicant and the co-signer when it comes to the responsibility for making payments on the loan.  Further, a bank can normally go after the co-signer without first collecting from the primary borrower.  Both the primary borrower and the co-signer are held 100% percent liable for the entire debt.  The co-signer cannot demand that the bank go after the primary borrower first for repayment of the loan.  This is true even when the co-signer does not hold title to any security (like Joey’s car) or control the payments.

The bank usually has no obligation to notify the co-signer if the primary borrower misses a payment. If the bank files a lawsuit against the co-signer, it does not have to name the primary lender in the case.  The co-signer would have to bring the primary borrower into the lawsuit.  In our scenario, it is very unlikely that Leon would file a formal claim against Joey.  Almost always, the co-signer has more to lose.  Creditors know this and won’t waste time chasing an uncollectible party.  Even if a co-signer settles a claim with the bank, he may have to report debt forgiveness income on his next tax return if the bank takes less than the full balance owed on the loan.

For car loans, the co-signer should understand that his name will not be listed on the title. He has no ownership interest in the collateral.  The co-signer can’t legally force the primary borrower to sign over the car title to him.  As in our scenario, the primary borrower may not obtain sufficient insurance to pay the loan balance if the vehicle is stolen or damaged.

Co-signers also risk taking a significant hit to their credit score.  The initial loan application will count as a credit inquiry which may temporarily lower the co-signer’s rating.  The new loan obligation will also affect the co-signer’s debt to credit ratio.  The co-signer may have difficulty in future loan applications of his own.  Plus, every time the primary borrower is late with a payment, the co-signer’s credit score takes a hit.

There are a few steps a co-signer can take to protect himself.  A co-signer should have the bank statements sent to him directly so he knows if payments are current.  Even better, the co-signer could require the primary borrower to send the payments to him.  That way, the co-signer can pay the bank directly and keep a good record of the loan activity.  If there is collateral involved in the loan, the co-signer should make sure that sufficient insurance remains in place.  Finally, if the co-signer cannot afford to pay the loan himself, then he should not sign on the dotted line.

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Michael Laribee is a partner in the Medina law firm of Laribee & Hertrick, LLP. This article is intended to provide general information about the law. It is not intended to give legal advice.  Readers are urged to seek advice from an attorney regarding their specific issues and rights.
 
 
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