If you have good credit and a stable income, you could help a close friend or family member get approved for a mortgage by co-signing his or her loan. A co-signer can be especially helpful now when claiming historic low mortgage rates means meeting high standards for approval. But whether you should co-sign a mortgage depends on whether you can afford the risk to your credit, finances and personal relationship with the borrower.
Here's what you should consider before co-signing a loan.
What Does It Mean to Be a Co-Signer on a Mortgage?
A co-signer shares the responsibility for payment of a loan. The co-signer is required to pay back the loan if the borrower doesn't and suffers negative credit consequences if the borrower misses payments.
As a co-signer, you're telling the bank you believe the borrower can make his or her payments -- so much so that if the borrower doesn't make payments, you're willing to step in to make them yourself.
If a mortgage application is initially turned down because it's too much of a risk, a co-signer could provide the assurance a lender needs to approve the loan. For example, an applicant who has a checkered credit history or a salary that's too low to handle monthly payments needs a co-signer with strong credit and income to assure the lender that the loan will be paid back.
"When someone co-signs on a mortgage loan, it means they agree to take responsibility for the loan if you default," says Viral Shah, co-founder and head of financial products at online mortgage lender Better.com. "A good way to think of it is as a legally binding contract that makes another person partially responsible for your debt."
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Co-signing is different from co-borrowing. While you share legal responsibility for the debt in either situation, as a co-borrower, you're expected to contribute payments even when the primary borrower isn't at risk of default. Co-borrowers also have a shared interest in the home, so both names would be on the title.
Can You Be a Co-Signer?
A co-signer should have better credit and income than the primary borrower. In some cases, a co-signer is a family member or friend of the loan applicant, such as a parent who wants to help a child get their first home.
"Ideal co-signers have stable income, low debt-to-income ratio and great credit in order to help qualify for a mortgage loan," Shah says.
Whether you qualify to be a co-signer and whether you should become a co-signer are two different questions, though. When you consider becoming a co-signer, take these steps:
-- Review the situation with a financial planner, as co-signing can affect your financial future.
-- Check your credit and your debt ratio to make sure you could handle the extra burden of another mortgage payment if the borrower can't make payments.
-- Look into how co-signing can affect your credit, now and in the long term.
-- Review state rights and regulations governing co-signers.
-- See if the creditor will share all the mortgage-related paperwork with you and notify you if the borrower isn't making payments.
-- Make sure the co-signer's obligations are clearly spelled out in the purchase contract.
-- Brainstorm alternatives to co-signing with the borrowers and lender.
Some requests for co-signing help could come halfway through the closing process or even a couple weeks before the closing date. Even when you're pressed for time, it's a good idea for the co-signer to get as much information as possible before making a decision, says Michelle T. Chase, a real estate attorney in Naperville, Illinois.
"It's so last minute -- how do you tell your kid that you can't help them get a mortgage? It gets emotional, too," Chase says.
What Are the Risks of Co-Signing on a Mortgage?
The primary risk of co-signing a mortgage is it becomes your responsibility if the borrower doesn't make payments. You're on the hook for the loan, so co-signing could hurt your credit and you could end up making the payments yourself.
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"There are tremendous risks to co-signing a mortgage, and it's important to understand the risks as you become just as responsible for repaying the obligation as the homebuyer is," Shah says. "If the person loses their job or is in a situation where they can't make their monthly payment, you're now responsible for paying that mortgage too. In addition to being stuck with that debt, it could seriously impact your credit."
A missed payment becomes a negative mark on your credit report. You might also have to cover late fees or collection costs in addition to the missed payments.
A late payment could cause your credit score to drop because your payment history makes up about 35% of the formula used to create your FICO score. Also, missed payments stay on your credit report for seven years.
The co-signed loan could also cause another problem, even if payments are being made: It could prevent you from getting another loan because of the amount of debt you're responsible for. For example, Chase says one of her clients could not buy a vacation home because she had co-signed a loan.
Also, relationships could be compromised, or worse, if the borrower doesn't come through with mortgage payments.
"You shouldn't harm your own credit to help (someone) realize their own dreams," Chase says. "Maybe they can't afford that house, maybe they should get a smaller home."
Becoming a Prepared Co-Signer
If you decide to take the plunge and become a co-signer, be prepared. Make sure you have all the key documents that have your name on them -- as well as a plan on how you will communicate and manage the loan with the borrower.
For example, make sure you:
-- Set aside enough money to cover mortgage payments in case the borrower misses one or more.
-- Arrange for the borrower to let you know if he or she expects to miss a payment. As a backup, ask the lender/loan servicer to advise you if a payment has been missed.
-- Find out how to log in to the mortgage online account so you can monitor the loan.
What Are Alternatives to Co-Signing?
If you have been asked to be a co-signer, understand the alternatives.
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Find help for the applicant. Several programs assist borrowers, including:
-- FHA loans. These government-backed loans allow for smaller down payments and more generous credit terms than conventional loans.
-- Down payment assistance. National, state and local governments as well as nonprofits offer these options, which include down payment grants, forgivable second mortgage programs and matched savings programs.
-- HomeReady Mortgages. Loans from this Fannie Mae program are available with a low down payment, lower income requirements and credit scores of 620 and higher.
Provide a gift. A cash gift could help loan applicants provide a larger down payment, which could decrease their monthly mortgage installment to a low enough level for them to sign the loan themselves. "For the purposes of that mortgage, it's a gift," Chase says. "The donor often has to sign a gift letter that they're not anticipating being reimbursed."
Buy the home yourself. As the co-signer, you'd need to have enough money to cover the monthly payment anyway, so it might make more sense to purchase it and collect rent. "You don't have to worry about the mortgage payment being made, because you're making it," Chase says.
Encourage a delay. If it doesn't make financial sense for the person or couple to buy a home, getting turned down for a mortgage could be a sign that it's not the right fit. "Maybe they should be buying a smaller home, or renting for a while and save more money," Chase says. "Maybe it's not the right time to buy that particular home."