On occasion, you, or someone you know, might be asked to co-sign a financial obligation for the purchase of a car or a house or the lease of an apartment or commercial space. Sometimes the request is simply to co-sign on a personal loan, so the borrower has access to needed funds. More often than not, this request is made by family and friends. But what are the risks? Is there a better alternative?
Though the term “co-sign” does not have universal meaning and application as the exact meaning is derived from the contract signed, it generally means that the person co-signing offers additional security to the person or entity offering the credit or financing (“creditor”) and takes on the same responsibility for payment that the original debtor takes on.
Take note of that meaning and the fact that it does not generally mean that the co-signer is alternatively liable. It means equal liability. Furthermore, in general, the creditor can pursue payment from either co-signer for the full amount owing to the creditor in the event of default.
It can become even more complicated for the co-signer because sometimes the contract specifies that all notifications for any signatories can just be sent to one party – call it the primary obligor. This is likely the person that you agreed to help and not the person co-signing.
Wrapping this all together so far, you could offer to co-sign, never receive notice of any deficiency, and then be liable for the total amount owing the creditor to include penalties and interest on a debt in the event the primary obligor fails to make timely payments. Your credit could likewise suffer. Some of the notice provisions can be altered in the contract to ensure that the person co-signing has actual notification, but the obligation for payment still stands.
It gets worse, though. The problem with co-signing is further compounded when dealing with assets where the creditor has a security interest (aka “collateral”) to support the repayment. This most often occurs with homes or cars.
To grant the security interest for the collateral, the person co-signing is often required to be put on the title of the asset to show ownership (and that ownership then allows the co-signer to grant the security interest for the creditor). Accordingly, in many co-signer situations, the co-signer is unintentionally also an owner of an asset.
Take a mortgage as an example. You help a child secure a house loan by both having your name on title and co-signing the mortgage. As discussed above, you therefore maintain liability exposure for the payment of the obligation. But, more than that, you are now an owner of an asset that might expose you to further liability.
For example, assume the house that was purchased had an attractive nuisance (See my previous column, “How to protect against attractive nuisances to avoid liability.”). Further, assume a child was injured on that property due to the attractive nuisance. You may have inadvertently exposed yourself and your assets to the child’s lawsuit against the owners of the property that contained the attractive nuisance. It can also be complicated to later try to remove your name from the title – even after any financial obligation is paid.
Is there a better way?
To some extent, the co-signer’s liability can be mitigated in a few ways.
First, the co-signer may choose not to be on the title of an asset (if possible) to reduce the potential liability associated with that asset.
Alternatively, the co-signer might ask that the property be placed in a limited liability company or other entity that can help shield an owner’s personal assets from debts of the entity (which could help in the premises liability issue but not relieve you of responsibility for the loan repayment).
But the smarter way is to try to avoid co-signing altogether if you can find another solution.
Often, a co-signer is necessary because the primary obligor lacks the funds or income to obtain the loan on his or her own.
Perhaps then, you can help the primary obligor to independently qualify for the loan. This is the preferred solution.
For example, perhaps you could gift $10,000 to help the primary obligor pay a higher down payment on a home so they can qualify for a better loan.
On the one hand, this might seem more generous than simply co-signing, but on the other hand, it puts a hard limit on the extent of the obligation. That is, no longer are you liable for the entire mortgage if there is a problem. No longer are you potentially liable for premises liability issues.
Instead, you are liable for only the amount you gave – your $10,000. The other option is to loan the money yourself. Of course, there’s many drawbacks to loaning money to family or friends (See my previous column, “Follow these rules when lending money to family, friends.”) but it just might be better than being on the hook for a debt to a third party for which you have little control.
Beau Ruff, a licensed attorney, is the director of planning at Cornerstone Wealth Strategies, a full-service independent investment management and financial planning firm in Kennewick
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