Why you should never co-sign a loan

By Mary Rowland
MSN Money

What could be worse than being head over heels in debt with little hope of climbing out?

Try this: Your child (parent, significant other) is head over heels in debt and your name is on the loan.

It happens all the time. I remember meeting a 41-year-old photographer who had recently divorced and inherited $21,000 of his ex-wife's debt. A friend who thought he was involved in a great relationship started picking up the tab for his soon-to-be ex-partner. A parent co-signed for a credit card for her college-age daughter and is now stuck with $30,000 in credit-card debt.

For those of you who are toying with helping out a partner, parent, sibling or child, don't do it by co-signing a note. Adding your name to someone else's debt is a very serious financial step.

"You should never co-sign a loan," says Lynn Brenner, a personal finance columnist. If the primary borrower gets behind in payments, "the bank will come after the person they have the greatest chance of collecting from. If they thought they had a good chance of collecting from your son, they wouldn't have required a co-signer in the first place."

A risk to your credit rating
When you co-sign a loan, you are signing a legal contract that holds you responsible for the entire debt, say consumer credit experts. If the borrower does not repay, it can be reported on your credit record. If it goes to a collection agency, the agency will try to collect from you.

But the bank can do more than ruin your credit rating. It can sue you and get a judgment against you for the amount of the loan plus interest. "You must go to court and disclose all your assets," Brenner says. "It can even force the sale of your house." And, if the document is like most loan guarantees, it allows the bank to charge you its own legal fees in collecting the debt from you. A typical loan document is written in very small print on two sides of an 8” x 14” piece of paper.

"Very often people sign it without reading it, particularly when they want to help a child," Brenner says. They assume that the lender will exhaust every means of collecting from the primary borrower before it comes after the co-signer. "But the agreement typically allows the lender to decide who to go after," Brenner says.

Collectors go after the person who offers the best chance of recovering the money.

If a loan becomes delinquent, a collector can choose to call you, harass you, rather than your friend or relative, if the collector sees that you have a much better repayment record. Even if the loan is repaid on time each month, another lender may consider the amount of debt that you co-signed when determining if you already have too much credit. In other words, if you’ve added your good name to someone else’s debt, it could be counted against you if you need a loan.

If you get stuck, try to negotiate
If you're already on the hook for someone else's debt, you may have to pay it off. Before you do that, you might try negotiating to see if you can get it reduced. That's what my new photographer friend did. He called the credit-card companies and offered to pay 65 cents on the dollar. It’s a little known fact, but you can negotiate with credit companies on how much you’ll pay of what is owed. Most credit-card companies will agree to a lower repayment amount rather than face having to wait months or years to get something -- if anything. In this case, the creditor countered with 85%. He ended up paying 75 cents on the dollar to settle the debt.

If you do that, be certain that you get a clean credit record as part of the negotiation. Get that in writing and follow up to make certain that your record is unimpaired. You should also negotiate a contract with the primary borrower before you pay off the debt.

Teens and credit cards
If you want to teach your teenagers about using credit, do it carefully. High school seniors are inundated by credit-card offers, says Gerri Detweiler, author of "The Ultimate Credit Handbook."

The average adult already has eight to 10 cards, so high schoolers are one of the few untapped markets. "They're a good risk because parents stand behind the debt," Detweiler says. Card issuers want them because teenagers tend to be loyal to their first card.

Establishing credit is an important step for young adults. It will help them rent their first apartment and perhaps help them get a job. But Detweiler says you shouldn't co-sign for a teenager because "you usually don't find out about unpaid bills until it's too late." The lender is not required to notify the co-signer until the primary borrower is in default, she says.

Detweiler suggests instead that you go through the mail solicitations with your teenager, pick a card and become the primary borrower yourself with your child as the co-signer. "He still gets the benefit of building the credit rating," she says. "But you get the bills so you know what's going on."

She also suggests that you set rules for what can be charged and how the bills will be paid.

If your child, parent, friend, is already in trouble, or if you are in trouble along with him or her, check out the National Foundation for Credit Counseling Web site. It also has a referral service for finding an office near you. Most lenders are happy to work with you when you indicate your willingness to whittle down the debt.

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