Cosigners on Student Loans: A Last Resort Option

Michael Lux Blog, Strategy, Student Loans 0 Comments

Banks and lenders love having people cosign student loans and refinance loans, but borrowers and their families should think twice.

When someone cosigns a loan, they agree to be legally responsible in the event that the original borrower fails to pay off the loan.  Many cosigners assume that if the person the cosign for is responsible, that they will have nothing to worry about.  This is a dangerous assumption.  Even under ideal circumstances, cosigning a loan has real drawbacks.

Cosigning a Student Loan: Best Case Scenario

Due to the presence of a cosigner, a borrower can true a loan application rejection into an approval.  Cosigners can also help borrowers secure lower interest rates.

Once the loan is issued, it will show up on the credit report of the borrower and the cosigner.  While the credit report may note that the cosigner is the cosigner and not the actual borrower, nearly all credit application decisions will be made assuming that the cosigner will be legally responsible for the debt.  This can negatively affect the cosigners credit score and their debt-to-income ratio.  In some circumstances, creditors will exclude the cosigned loans from their approval calculations, but this is the exception and not the rule.  Additionally, in an era where most of these decisions are done automatically by a computer, having a cosigned loan on your credit report can be a major detriment to buying a house or even getting a car loan.

This issue is especially true for cosigners who are on loans where the borrower is still in college.  The lender may not even report a monthly payment on the credit report, and future creditors may make assumptions that grossly over estimate the future obligations of the cosigner.  For cosigners attempting to purchase a home while a borrower is in college, this issue get especially ugly.

Thus, even when the borrower has never missed a payment on the loan, cosigners can still run into issues.

Ugly Circumstances for Cosigners: The Worst Case Scenarios

Most college students seem like a good bet to pay off their debt… especially to friends and loved ones.  They have done the work to get admitted, and they are working towards a degree that should lead to a good job and a good income.

Unfortunately, not all college students get high paying jobs.  Some don’t even get jobs in their fields.  Others don’t even graduate.  In some cases, student irresponsibility can lead to these failures.  Other times, the issue is not the fault of the student at all.  Industries change.  Job markets can decline.  Health and circumstances may crate a situation where the loan borrower no longer can afford their debt.  Because there are so many unknowns, cosigners are usually told to assume that they should be financially prepared to take over loan payments.  Nobody expects it to happen, but it happens all the time.

In the event the borrower is unable to pay off the loan, the cosigner becomes a de-facto debt collector.  The lender makes it clear that either the borrower pays up, or the cosigner will have to.  Cosigners may feel obligated to track job searches and monitor spending so that the borrower is able to meet their obligations.  This can have a devastating impact on any family or friendship.

Lenders also have been known to enforce some strange policies on student loan cosigners.  If a borrower dies or becomes permanently disabled, it does not necessarily mean that the cosigner is off the hook.  In many cases the terms of the loan contract will determine the outcome.  For some families, the tragic death of a child can lead to financial hardships as well.  For this reason it is critical to understand the terms of the loan agreement and, if necessary, to have a life insurance policy in place to protect the borrower or the cosigner.

Don’t Count on a Cosigner Release

Many lenders like to advertise that they have “cosigner release” policies.  The idea behind this policy is that cosigners can feel more comfortable signing for the loan because it is a short term obligation if they can get released.  The problem is that actually getting released is difficult.  When there is a cosigner on a loan, the lender has two people legally responsible to pay off the debt.  There is almost no incentive to remove one of these individuals.  As a result, when a borrower applies for a cosigner release, they should expect that getting credit approval will be very difficult.  The Consumer Financial Protection Bureau has shed some light on this issue.  Though they sound appealing, cosigner releases rarely happen.  Typically, the best route to a cosigner release is for the borrower to refinance the loan in their own name.  By paying off the old debt in full by refinancing, the cosigner released from any further obligations.  Outside lenders are far more likely to refinance than an existing lender is to grant a cosigner release.

Bottom Line

Cosigners on student loans can cause financial problems and family problems.  With major potential downside and little benefit, having a cosigner should be viewed as an option of last resort.