Cosigning is one of those instances where acting on your emotions can place your finances at risk. You really want to help that family member, friend or loved one get approved for a loan they may not qualify for, so deciding to cosign for them can seem like an act of generosity when their chances of obtaining new credit are next to nil.
But by cosigning your name next to theirs, you’re not just sharing the strength of your creditworthiness with someone else – you’re agreeing to take full responsibility for that credit card, car loan, or student loan if they can’t (or for some reason, won’t) pay. If they become delinquent or go into default, it’s up to you to fulfill the debt and take over their payments, effectively making you, the cosigner, the primary borrower on a loan that wasn’t even yours to begin with.
What happens when cosigners have to take on unexpected debt? For starters, it puts your exemplary credit at risk. Aggressive collectors may start pursuing you to pay up. And a legal judgment may eventually be issued against you if payments aren’t made on time, or if you also go into default.
Worst of all, it could also place strain on the relationship with the person you’ve cosigned for, be it a child, spouse or other relative.
Dealing with the damage
As dire as this all this may sound, there are some ways to avoid these outcomes if you’re dealing with a defaulted loan you cosigned on. The bad news with a cosigned default is that at the end of the day, you still owe the money; the good news is that considering these alternatives can lessen the burden:
Request a forbearance
Temporarily stalling repayment of a loan is commonplace in the world of student loans, but once a loan has gone into default, forbearances usually aren’t an available option any longer. That doesn’t mean you can’t try contacting your creditor(s) to obtain one. They may grant you a short hold on the loan, which can give you (or the person you cosigned for) enough leverage to get your finances back on track, and your lender, a better chance of being paid back.
"Depending on the nature of the loan, this could be a successful solution, as forbearance often gives a lenient window," says Sacha Ferrandi, founder of Source Capital Funding. "A forbearance also prevents the (borrower) from missing more payments."
Refinance the loan
Lenders may be reluctant to refinance a loan if it’s been in default for some time and your primary borrower’s credit was poor to begin with. But your credit standing may still give you a chance to obtain new terms, a new interest rate and a new payment schedule if it means paying the loan off.
If a good portion of the loan was paid off prior to default, the borrower you cosigned for may be able to obtain a refinance on their own. If not, you might try refinancing yourself. Be careful going this route, however, since the loan is now entirely in your hands to pay off completely. If you’re juggling other debts, even the most ideal refinanced terms may be hard to squeeze into your budget.
Borrow money to pay off the defaulted loan
Taking out one loan to pay off another may seem counterintuitive. If you’re in default on one loan, won’t the same happen on the other? Some debt consolidation companies or private lenders may be willing to take the risk and work with you; but be aware that like consolidation or refinancing, you or your cosigned borrower are still responsible for paying the new lender the new loan.
Sell the asset
It can be difficult to part ways with a car or house you’ve been working to pay down, but in the event of default, selling it may be your best recourse to recouping the cost, paying back the lender, and preserving your finances with minimal losses. Taking the initiative here can prevent the situation from getting worse as default status wears on, since you want to avoid repossession, foreclosure or seizure of the asset.
You should keep in mind that this can leave the borrower without transportation or a home to live in, so treat this option with sensitivity. "This is the first, and maybe the hardest part," says Peter Hoglund, a Certified Financial Planner©. "If your family member is using the asset, they are going to lose access to it and have to find an alternate solution."
File for bankruptcy
Ah, the dreaded "B" word. For a student loan, you may be out of luck, since they’re rarely, if ever, eligible for bankruptcy. But for other loans, it may help get you off the hook. Short of selling your soul, always approach bankruptcy as a last resort if you’ve examined every other available option, since it can be one of the biggest black marks your credit report will ever see. Even if the defaulted loan is successfully discharged, future lenders and creditors may be reluctant to work with you.
If you don’t want to even think about filing bankruptcy, some experts suggest that at a minimum, it can be used as a steady negotiation tactic for requesting new loan terms from the original lender.
Find ways to pay up
"If you’re the cosigner, you’re the co-borrower," says Certified Financial Planner George Guerin. "You’re on the hook from it going into default. You have only one choice: Make the payments." Thus, your most basic solution is to chip away at the debt yourself in any way you can.
"You need to start thinking about it like your debt and prioritize removing it," says Hoglund. "If it is not fully in default, make a payment out of your own pocket, which will buy you some time." However, if it’s gone past the point of delinquency and into full-on default, examine your budget and see where you can fit in some unexpected payments.
Can you use your savings or emergency fund as a buffer? Consider withdrawing from retirement accounts, like your IRA, but remember that this can come with penalty fees. Are there investments you can sell off, using the proceeds towards the defaulted debt? Or, in the day-to-day, are there ways to cut back on you spending to free up cash to repay the lender?
Preserving the relationship
As if facing catastrophic loan default isn’t bad enough, a failed cosigning can also mean a strained relationship between both parties, whether it’s a parent and child, husband and wife, or just two friends.
Once the loan is in default, communication is key. Don’t treat each other like enemies. Approach the situation non-judgmental of the other person. Meet them face to face and work towards building a plan to get the debt solved.
"You don’t want to lose the family member/friend, so this is the time for a full sit-down meeting," says Hoglund. "Be direct and be very prepared with detailed numbers: we owe this much money, we don’t have enough to pay the ongoing bills. Try and set yourself up as the solution-oriented one, not critical of whatever resulted in the default, but simply looking to help both of you out of the problem.
"It’s going to be painful," Hoglund notes. "Now is the time for you to patiently listen, but also to be firm and direct, that the sale needs to be completed as soon as possible."
When neither you or the relative or friend you cosigned for can afford to salvage the defaulted loan, one solution is to work together collaboratively to pay it back in full. "Set up a repayment system outside of the loan parameters, where you pay the official loan and the defaulter pays you as they can," says Ferrandi.
Ferrandi suggests setting up a direct deposit system in this case. Have the defaulted borrower deposit their payments directly into your bank account; then, once the money is in your hands, take the lead and make the payment directly to the lender. By taking this supervisory role, you can slowly pay the loan off while minimizing damage to your credit and theirs. It’s another way of working together to preserve your relationship while paying back the money you owe.
Preventing the default
Before debt, delinquency or default ever enter the picture, carefully examine if cosigning is the right thing for you or the person you’d like to cosign for.
"If there was ever a thing to avoid, it would be not to cosign at all for a relative or friend," says Guerin. "Circumstances change."
If it’s a non-relative, or someone you don’t know well, Guerin recommends taking a conservative approach to ensure cosigning is the right decision for you. "I would pull their credit score," he says. "Somebody who has a bad credit score, there’s a reason they do."
If they have a poor FICO score, ask them about it. Don’t be accusatory, says Guerin, but if excuses are made, you may reconsider if you want to place your finances and credit at risk.
With a close family member, you may be reluctant to cosign, but you still want to help. Guerin says that fronting some money for a down payment may be a good alternative to full-on cosigning.
"It sometimes looks like tough love," he says, "but it’s a difficult world, especially when you’re taking on someone else’s liability."
Going into the situation with a clear perception of what cosigning is can alleviate the financial and personal strain that can be created if anything goes awry with repaying the debt. Straightforward as it may seem, misconceptions abound when it comes to the real nature of a cosigning agreement.
"Most people who I talk to don’t understand what cosigning is," says Michael Sullivan, a personal finance consultant with Take Charge America. "They think it’s some kind of character promise – that this is a good person. They don’t understand they’ve taken on the debt and they have to take on those payments."