The economic distress of the last year has battered the credit scores of many potential borrowers, while causing lenders to increase the scores they are willing to accept. The result is a growing number of co-signing requests. Co-signing arises when one party with good credit agrees to be liable for the debt of another party with no or poor credit.
Some co-signers have had their lives severely disrupted when the borrower for whom they co-signed stopped paying, leaving it up to the co-signer to make the loan good. Most of the mail I get on the subject is from co-signers in this situation. They now regret they did it, and invariably ask me how they can get out of it.
The answer is that a co-signer can’t get out from under his obligation without the permission of the lender, which he cannot get. A lender won’t let a co-signer off the hook because the borrower has defaulted. The possibility of default by the borrower is why the lender required a co-signer in the first place.
On the other hand, probably the great majority of cases of co-signing have a happy ending. Stories with happy endings seldom get into my mail box, but I had one in my own family that illustrates the potential benefits of co-signing. When my younger son left the military, he had no credit but needed an automobile, so I co-signed his note. Within 18 months, he had paid off the loan and his credit was well established. I never had to co-sign for him again.
I co-signed his note because he was my son, but that was only part of the reason. The other part was that I had information about him that the lender did not have. Specifically, I knew he was a straight arrow who always met his commitments.
Co-signing fails when the borrower defaults and the co-signer has to make good on his pledge. Why does this happen? Sometimes a responsible borrower draws a bad card from the deck of life, such as illness or job loss. A co-signer can’t avoid that risk. The risk one can and should avoid is co-signing for someone who is not responsible.
I recently read through some of the letters I have received where co-signing ended in default by the borrower, and severe distress for the co-signer. What struck me was that in most of these cases the co-signers had no better information about the capacity and willingness of the borrower to repay than the lender. Indeed, in many cases, the co-signer had persuasive evidence that the borrower was not reliable, but instead chose to ignore that evidence.
Why? Usually the reason was strong feelings of obligation to help a relative, friend or lover. The guilt they would have felt in refusing, along with the fear that refusal would destroy the relationship, overwhelmed their better judgment. When it is someone near and dear, it is hard to say no.
But if you are not fully confident that, absent unusual circumstances, the borrower will meet her obligation, "no" is what you need to say. It can destroy the relationship — that’s the borrower’s call — but the relationship will also be destroyed if she defaults. And if that happens, your financial security could be destroyed with it.
How Much Financial Help Should You Give?
"My daughter and her soon-to-be husband want to buy a house immediately after their marriage, but they are not yet settled in their professions and have no savings. What do you think of the idea of my buying the house for them to move into, and selling it to them after they have acquired the means?"
I assume you can afford to do this, but even so I don’t think much of the idea. In my view, it would constitute excessive parental intrusion into a critical area of your daughter’s life, with a major potential for future conflict.
Where they can afford it, I think it is great for parents to provide a helping hand to children who want to become homeowners. But a "helping hand" is not the same as taking over the process, which is what you propose. That is fraught with dangers, not the least of which is that the children never develop the discipline and maturity needed to become successful homeowners on their own.
An example of a helping hand is gifting the couple some of the cash they need for down payment and settlement costs. You do this after you are satisfied that they have a good marriage, adequate income and good credit. If they don’t need the cash but their credit is weak for reasons that you know to be temporary and not in character, a helping hand could consist of co-signing.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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