Credit: It seems you need it for everything these days. That’s probably why so many well-intentioned parents are cosigning loans for their kids. Although a few good reasons exist for parents to consider cosigning a loan for their children — helping them buy a car or home, or to establish a credit history — cosigning can have huge financial consequences. Here’s why you should never cosign loans for your kids.
Your Credit at Risk
Here’s how cosigning works: If someone with no credit history requires a loan, the bank might be unable to deliver — after all, it has no idea how much risk they’re taking by loaning money to a credit newbie. The cosigner steps in at this point. Essentially, the cosigner vouches for the potential borrower based on the cosigner’s own credit history.
The bank wants to have someone on the hook in case a loan is not repaid; if you cosign a loan, you’re that person who is on the hook. So if your child doesn’t make his loan payments, you will be expected to do so — or risk suffering the impact of a defaulted loan on your credit score. Plus, as a cosigner, that loan is considered part of your credit history, which means it can affect how much you’ll be able to borrow yourself.
“Co-signing on its own doesn’t have a negative impact on your credit,” said financial lifestyle coach Carrie Pink. “However, it is added on your list of outstanding debts on your credit report and increases your debt-to-income ratio — which can affect your ability to borrow in the future.”
Too Much Risk for the Bank Means Too Much Risk for You
Lenders have reliable systems for judging how likely a person is to repay a loan. After all, making money is their business. So if the bank says your child isn’t ready to take out an auto loan, for example, it might have a point. Whether your child has poor credit or no credit, both are signs of a lack of experience responsibly borrowing money. If the bank believes the risk is too great, you should carefully consider whether this is a risk you should bear.
Although cosigning doesn’t have a negative impact on your credit, for the cosigner, this loan practice still has many risks and few rights. If you cosign a loan, whatever it is used to pay for — whether that’s a car, a home or some other major purchase — belongs to your child, but the responsibility to pay for it is yours.
“The risk is always late payments or default as it will hurt the cosigner’s credit as if it was on him as well, since the cosigner is guaranteeing the loan,” said Reid Waltzer, vice president of First Choice Loan Services.
Unfortunately, a scenario in which you are forced to swoop in to rescue your children when they make poor financial decisions is not an accurate reflection of how the real world works. In reality, they’ll be expected to atone for their own financial blunders, and debt collectors will hound them directly.
Risk to Personal Relationships
Another important risk to consider with a cosigned loan is the effect it could have on your relationship with your child. “When late payments occur, that will generally create animosity between the parties,” Waltzer said. That animosity can be even more complicated when it occurs between a parent and child.
If your goal is to teach your kids about how to use credit responsibly, cosigning on a loan might not accomplish that goal. The emergencies-only credit card you give them might be used to pay for a spring break trip to Cancun — and you will have no choice but to foot the bill or have your credit score be hurt.
“Good intentions are not enough to keep bills paid,” said Pink. “When a cosigned loan goes bad, the cosigner will often feel betrayed as well as angry and inconvenienced.” The borrower might also feel also guilty and embarrassed, and hide or ignore the debt. “It’s a bad scenario all around,” Pink said.
Building Credit Is Learning Credit
The drawback to not cosigning a loan for your kids is that it will take longer for them to start building their own credit. The issue has become a greater concern since the Credit Card Accountability, Responsibility and Disclosure Act of 2009 made it much harder for those under the age of 21 to open a credit card. Unfortunately, the reason this provision of the act was introduced is because an increasing number of young people were racking up thousands of dollars of credit card debt before they even had an income to begin paying it off.
Credit can be helpful, but taking things slow is not a bad thing. After all, it makes a lot more sense for kids to get their first credit cards after securing their own sources of income. In this way, they will learn how credit works and what it takes to pay it off. Kids will likely make some poor financial decisions, but this is the best way to learn how credit actually works.
Alternatives to Cosigning a Loan for Your Kids
Cosigning a loan isn’t your only option for helping out your children financially. Other, effective means are available for helping maintain your good relationship and provide the funds they need — at little risk to your own credit. Consider a few alternatives to cosigning a loan.
Help Kids Develop a Plan to Build Credit or Save
Teach children to build savings for big purchases and to save for themselves, so that borrowing money or having to get a cosigner is less likely. “Help them develop a savings plan or a credit plan so they can be in a better position to secure the credit they need on their own in the future,” Pink said.
“I personally teach my kids that they will always budget better and spend less when using cash,” said Pink. “There is a pain associated with tangible money that doesn’t exist when you swipe a debit or credit card.”
Lend Money Directly to Your Child
If one of your children is facing a tough financial situation, turning down a request to cosign a loan doesn’t necessarily mean you’re hanging him out to dry. One of the best alternatives to cosigning a loan is to lend money to your child directly. You could lend him $500 to get a secured credit card or for seed capital to put toward his own financial goals. After all, this is essentially what you’re doing when you cosign, but with a direct loan, your credit is not at stake if your child doesn’t pay you back.
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If debt’s already a problem for your child, offer to pay for a visit with a financial planner or debt counselor who can help your child build the skills he needs to get out of debt — and stay out for good.
Give a Lump-Sum Cash Gift
If your child wants a car, for example, shell out $500 for an old car that will get your son or daughter to and from work. “Why finance a new car when a used car is new to [your child]?” said Pink.
“Give your child a lump-sum cash gift to help toward paying whatever it was they needed the loan for,” Pink said. At the same time, you can teach him to spend only what he can afford.
Avoid Cosigning Loans by Teaching Financial Responsibility — and Patience
It’s inevitable that children will learn about credit; it’s everywhere, which is why parents should do their best to share their own experiences with borrowing to help shape how their own kids think about it.
But the first financial lesson kids need to learn is how to live on cash. If they can master that, they are much less likely to fall into a vicious cycle of debt. Rather than being in a rush to initiate them into the world of borrowing, teach them how to budget and get by on what they have. It’s a financial lesson that will serve them better than any credit score and will help them develop the skills that will allow them to build a solid FICO score on their own some day.
“I advise parents to start teaching their children about finances at a very young age,” said Pink. “Children as young as five or six can understand the basic concepts of financial literacy. That includes explaining to them that credit is a loan — not free money.”
Credit is made out to be so important that many parents jump on the bandwagon to get their children started on building a score. In doing so, they might be missing the point. Kids have plenty of time to build a credit score, but helping them do it might not teach them what it takes to manage credit and, most importantly, how to live without it.
“Needing a cosigner means you aren’t financially ready or capable to handle the item or situation you are trying to pursue. Don’t let your impatience cost you,” Pink said. Whatever you do, make sure it involves making your kids work for what they want — and feeling the sting of poor financial decisions.
Ruth Sarreal contributed to the reporting for this article.