Cosigned a relative's loan? Here's how to deal with a default
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Updated April 8, 2019: Cosigning is one instance where acting on your emotions can place your finances at risk. If you really want to help a family member, friend or loved one get approved for a loan they may not qualify for, cosigning for them can seem like an act of generosity when their chances of obtaining new credit are next to nil.
But by cosigning their loan, you’re not just sharing the strength of your creditworthiness. You’re agreeing to take full responsibility for that credit card, car loan or student loan if they can’t — or won’t — pay. If they become delinquent or 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 yours to begin with.
What happens when cosigners have to take on unexpected debt? For starters, it puts your credit at risk. Aggressive collectors may pursue you to pay up. And a legal judgment may eventually be issued against you if you don't make payments on time, or if you also go into default.
Worst of all, it could place a strain on the relationship with the person you’ve cosigned for, be it a child, spouse or other relative.
As dire as this may sound, you can avoid these outcomes if you’re dealing with a defaulted loan you cosigned. The bad news with a cosigned default is that you still owe the money. But taking these actions can lessen the burden:
Temporarily stalling repayment of a loan is common in the world of student loans, but once a loan goes into default, forbearances usually aren’t an option any longer. But you can still try contacting your creditors 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 and Texas Hard Money. "A forbearance also prevents the (borrower) from missing more payments."
Lenders may be reluctant to refinance a loan if it’s been in default for some time and the 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 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 will be your responsibility to pay off completely. If you’re juggling other debts, even the most ideal refinanced terms may be hard to squeeze into your budget.
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 like consolidation or refinancing, you or the cosigned borrower are still responsible for paying back the new lender.
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 repossession, foreclosure or seizure of the asset.
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."
For a student loan, you may be out of luck, since they’re rarely, if ever, eligible for bankruptcy. But for other loans, bankruptcy may help get you off the hook. Approach bankruptcy as a last resort if you’ve examined every other option, since it can be one of the biggest black marks your credit report will see. Even if the defaulted loan is discharged, future lenders and creditors may be reluctant to work with you. (Learn how bankruptcy affects life insurance.)
If you don’t want to file for bankruptcy, the threat of it can be used as a negotiation tactic for requesting new terms from the lender.
"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.
"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 individual retirement account, though this can come with penalty fees. Are there investments you can sell to put proceeds toward the defaulted debt? Are there ways to cut back on your spending to free up cash to repay the lender?
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 two friends.
Once the loan is in default, communication is key. Don’t treat each other like enemies. Approach the situation without judging the other person. Meet them face to face and plan to solve the debt.
"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 says. "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. Have the defaulted borrower deposit their payments directly into your bank account; then, once the money is in your hands, 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.
Before debt, delinquency or default enter the picture, decide 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 someone you don’t know well, Guerin recommends taking a conservative approach to ensure cosigning is the right decision. "I would pull their credit score," he says. "Somebody who has a bad credit score, there’s a reason they do." (Learn why you need to pay attention to your credit score.)
If they have a poor FICO score, ask them about it. Don’t be accusatory, says Guerin, but if excuses are made, consider whether 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 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 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."
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