Do you own your own home? Do you want to? Did you buy it with your partner?
For the past few decades, the appreciation of real estate in several high-demand markets has significantly outpaced income growth in the same locations.
If you want to live in Sydney, London, New York, Toronto, Vancouver, or Los Angeles, the prices of real estate have skyrocketed. As personal incomes fall further and further behind, the financial ability of tens of millions of millennials and Gen Y-er’s falls short of the bar.
If you want to “get into the market”, you might be forced to consider other alternatives. For the extremely fortunate, there are family members able to provide financial assistance to get over that down-payment hurdle. But the vast majority of people simply don’t have that luxury.
Another alternative that is more frequently coming up is having someone co-sign the loan.
But co-signing a loan comes with its own risks, more heavily weighing on the co-signer.
Borrowing Against Your Future Options
Debt is a financial tool, one that comes with its own rules. While any tool can be used to your advantage, you need to understand the rules before you play the game. The important element for a co-signer to understand is that the debt is effectively considered theirs.
If you co-sign a loan for someone else, that debt goes on your credit report. This extra use of credit could be a benefit, by diversifying your lists of financial instruments. But, that additional debt also increases your debt utilization.
Having too much debt can create difficulties in obtaining more. And when you’re a co-signer and not receiving a direct reward, losing those debt options can put you in a bad spot financially.
High Risk, Low Reward
When you co-sign a loan, you are taking legal and financial responsibility for those debts. While it might feel good to help a family member or friend out, those financial obligations don’t provide a return outside of that good-will feeling.
While generosity might be a key to finding lasting happiness, taking on too much risk for a low reward doesn’t balance the equation.
Keep in mind, that you are needed to co-sign a loan because the other party isn’t financially established enough on their own. While that may be of no fault of their own, that doesn’t change the implications. The primary borrower is too risky to loan to without collateral. And you are becoming that collateral.
Additional Work for You
Similar to the low-reward, co-signing a loan takes on an additional administrative burden.
While you might not ever need to pay any of the installments, you certainly need to know when and how much is being paid. Understanding the terms and obligations of the loan is essential, since the loan is effectively yours.
There is also the on-going burden of checking in, making sure those payments are being made on time, every time. This type of routine cadence puts an extra check-in in your calendar. Not to mention, you’ll need to become very comfortable talking about financial topics with the primary borrower.
The Downside of Your Legal and Financial Responsibility
If all the rest sounds like work to you, you’re right. Co-signing isn’t a simple “good deed”. You are financially responsible.
Ultimately that means if the debt isn’t being paid, you are on the hook. You could get sued over the loan, and you would have to pay the entire balance.
Often that legal measure falls on your lap as the co-signer first. The lender is looking at how best to recover their loan, and as we already mentioned, you as a co-signer are likely in the stronger financial position. For a lender, that simply means you are more likely to pay-up than the primary borrower who is defaulting.
The Hidden Cost of Settling
Of course, not all co-signed loan cases end up being paid out in full. If it comes to that, often the lender will be willing to take a settlement. Those settlements could result in you paying only a fraction of what was originally borrowed.
But a settlement isn’t as good news as it might sound at first.
Under both US and Canadian tax laws, any amount less than the original principal that is settled on must be considered as income. Let’s say you owe $ 500,000 on a co-signed loan where the primary borrower has defaulted. The mortgage company might accept payment of $ 400,000 to discharge the loan.
That settlement results in a $ 500,000 (principal) less $ 400,000 (settlement), or $ 100,000 gain to income for the co-signer. This perceived gain (income) increases the income taxes that must be paid.
Important Note: If you are in this situation, go straight to a licensed tax accountant. The additional complexities require professional guidance to have the best tax results.
Co-signing a loan, for whatever purpose, carries significant financial considerations. Whether you’re helping a family member break into the real-estate market. Or you’re simply consolidating financial resources with your significant other, knowing the implications of co-signing a loan is important.
Debt is an important tool in your financial toolbox. Understanding how to use it, especially with and for others, can open doors that might otherwise be shut. But, don’t open those doors without knowing first what you’re letting loose.