September 5, 2017

I’ll bet that many people have, and usually right after something they co-signed for has gone awry.   Most people seem not to think of it this way – when they hear about loan refusals or people not qualifying for a mortgage and so on – but banks are in the business of lending money. Banks actually want each of us to be as far in debt, to them, as we can possibly be, yet still manage to pay them back with regular monthly payments.

Risk aversion is a term we often hear the banks use in relation to lending – but ironically it is not something that consumers often apply to their own scenarios.   Perhaps we are more optimistic than the average banker?  In any event risk aversion is based on a number of variables.  In the simplest sense we might think about different types of lending and the risks associated with them.  For instance mortgages have tended to be far less risky than car loans. Why is that?  It is because real property historically has tended to appreciate in value while car values depreciate. In theory at least when we get to the end of the term of a mortgage the house should be worth more (expressed as a ratio of value) than the loan amount whereas the car, in some cases, may not even worth the last payment on the loan.

So how does the bank mitigate (lessen) its risks when lending?  One method is to simply share the responsibility so that if one person defaults there is someone else to pick up the tab.  If you are a high risk borrower your banker might ask “have you got a co-signer?”    

Many people seem to think of a co-signer as being a “recommender“, something akin to a reference on a resume.  While it is true that I may be able to count on a former employer to recommend me for a new job it is doubtful that I would be able to get their backing to borrow money.  Imagine the bank manager asking for a co-signer so you rush out into the street and notice a guy in a dapper suit getting out of a high end automobile – you say “pardon me sir, would you mind co-signing a bank loan for me, I promise I’ll pay it back“.

Yeah, so that sounds ridiculous, right?  But think about it for a minute, you have no trouble going to a relative and asking them to co-sign?  In a sense there is an even greater element of absurd recklessness – you would expose a close family member to a higher financial risk than a complete stranger.  But that’s exactly what many people do.

If common sense were to prevail, why on earth would someone co-sign a loan?  It is obvious that the bank has deemed the primary borrower to be a “high risk” or they wouldn’t need a co-signer to begin with.   So is it from guilt, emotional pressure, a sense of duty or an element of naivetŽ?

I am betting on naivetŽ.  All too often the co-signer finds out that, in the end, they are responsible for the full amount of the outstanding loan, plus accrued interest when the primary borrower reneges on their responsibilities.  When the co-signer is a spouse there is often the delusion that “I am only responsible for my half“. Think again sweetheart, the co-signer shares the full responsibility for repayment along with all the terms.

If you are considering co-signing for a family member you must be prepared to pay the full debt on their behalf – if not don’t co-sign.  Keep in mind too that if you are co-signing for a mortgage you might be further ahead to put up the money for the mortgage from your own investments (talk with you financial advisor) or get yourself on title on the property as a joint tenant.  

This week we saw a situation at the office where a parent co-signed a first mortgage (but was not on title) the daughter tore the house apart, with the best of intention of completing a renovation, but in so doing significantly devalued the property.  The daughter also, unknown to the co-signing parent, had taken out a second mortgage on the property and that was in default.

The parent in this case has no rights to the property at all, as they are merely a co-signer and not a co-owner, but is indentured to the mortgagee for the first mortgage.  As the first mortgage is paid down, by the parent (and possibly at some point the daughter finishes the renovations accelerating the equitable value of the property, or house values increase over time) the equity in the property will inure to the benefit of the second mortgagee

The second mortgagee can sit back adding interest and charges to the mortgage over a term of up to ten years before becoming statute barred.  So even though the parent is not directly responsible for the second mortgage by paying for the first they are effectively paying the second by creating the equity necessary to ensure it gets paid out.

Save your relationships they are more important than money – don’t co-sign!