Several points are worth highlighting:
- The lender does not have to chase the borrower before coming to you for repayment—you are on the hook every bit as much as the borrower.
- It is your loan, even if you won't have any use or enjoyment from the property. If there is a default, you will have to pay the obligation, in full, plus any "expenses" of collection.
- The lender does not feel confident that the buyer will be able to repay, or it would not be requesting a co-signor. That means the lender already has you in its sights the minute you pick up that pen to co-sign.
If you do cosign:
- Make sure you can afford to pay the loan—the odds are good that you will have to. If you are asked to pay and cannot, you could be sued, or your credit rating could be damaged.
- Consider that even if you are not asked to repay the debt, your liability for this loan will appear on your credit record. Having this "debt" may keep you from getting other credit that need or want.
- Before you pledge property, make sure you understand the consequences. If the borrower defaults, you could lose these possessions.
There is good reason why one law school professor defined "co-signer" as "an idiot with a fountain pen." The same reasoning applies, to a lesser extent, with a joint credit account.
Consider the Sources of Consumer Credit
We all have short-term or long-term needs for money or credit. You'll want to familiarize yourself with your options when your needs for credit arises.
Commercial Banks
Commercial banks make loans to borrowers who have the capacity to repay them. Loans are the sale of the use of money by those who have it (banks) to those who want it (borrowers) and are willing to pay a price (interest) for it. Banks make several types of loans, including consumer loans, housing loans and credit card loans.
- Consumer loans are for installment purchases, repaid with interest on a monthly basis. The bulk of consumer loans are for cars, boats, furniture and other expensive durable goods.
- Housing loans may be for either residential mortgages, home construction or home improvements.
- Credit card loans may be available in the form of cash advances within prearranged credit limits.
Savings and Loan Associations (S&Ls)
As depicted in It's a Wonderful Life, savings and loan associations used to specialize in long-term mortgage loans on houses and other real estate. Today, S&Ls offer personal installment loans, home improvement loans, second mortgages, education loans and loans secured by savings accounts.
S&Ls lend to creditworthy people, and usually, collateral may be required. The loan rates on S&Ls vary depending on the amount borrowed, the payment period, and the collateral. The interest charges of S&Ls are generally lower than those of some other types of lenders because S&Ls lend depositors' money, which is a relatively inexpensive source of funds.
Credit Unions (CUs)
Credit Unions are nonprofit cooperatives organized to serve people who have some type of common bond. The nonprofit status and lower costs of credit unions usually allow them to provide better terms on loans and savings than commercial institutions. The costs of the credit union may be lower because sponsoring firms provide staff and office space, and because some firms agree to deduct loan payments and savings installments from members' paychecks and apply them to credit union accounts.
Credit unions often offer good value in personal loans and savings accounts. CUs usually require less stringent qualifications and provide faster service on loans than do banks or S&Ls.
Consumer Finance Companies (CFCs)
Consumer finance companies specialize in personal installment loans and second mortgages. Consumers without an established credit history can often borrow from CFCs without collateral. CFCs are often willing to lend money to consumers who are having difficulty in obtaining credit somewhere else, but because the risk is higher, so is the interest rate.
The interest rate varies according to the size of the loan balance and the repayment schedule. CFCs process loan applications quickly, usually on the same day that the application is made, and design repayment schedules to fit the borrower's income.
Sales Finance Companies (SFCs)
If you have bought a car, you have probably encountered the opportunity to finance the purchase via the manufacturer's financing company. These SFCs let you pay for big-ticket items, such as an automobile, major appliances, furniture, computers and stereo equipment, over a longer period of time.
You don't deal directly with the SFC, but you are generally informed by the dealer that your installment note has been sold to a sales finance company. You then make your monthly payments to the SFC rather than to the dealer where you bought the merchandise.
Life Insurance Companies
Insurance companies will usually allow you to borrow up to 80 percent of the accumulated cash value of a whole life (or straight life) insurance policy. Loans against some policies do not have to be repaid, but the loan balance remaining upon your death is subtracted from the amount your beneficiaries receive.
Repayment of at least the interest portion is important, as compounding interest works against you. Life insurance companies charge lower interest rates than some other lenders because they take no risks and pay no collections costs. The loans are secured by the cash value of the policy.
Pawnbrokers
Recently made famous by reality shows, pawnbrokers are unconventional, but common, sources of secured loans. They hold your property and lend you a portion of its value. If you repay the loan and the interest on time, you get your property back. If you don't, the pawnbroker sells it, although an extension can be arranged. Pawnbrokers charge higher interest rates than other lenders, but you don't have to apply or wait for approval. Pawnbrokers' chief appeal? They rarely ask questions.
Loan Sharks
These usurious lenders have no state license to engage in the lending business. They charge excessive rates for refinancing, repossession or late payments, and they allow only a very short time for repayment. They're infamous for using collection methods that involve violence or other criminal conduct. Steer clear of them. They are illegal, after all.
Family and Friends
Your relatives can sometimes be your best source of credit. However, all such transactions should be treated in a businesslike manner; otherwise, misunderstandings may develop that can ruin family ties and friendships.
And, if the IRS catches wind of an intrafamily "loan," it can "impute interest" on the loan—which would be income to the lender, but not deductible to the borrower. Being caught up in an IRS audit can also blight family relationships.
Tax Disadvantages of Consumer Credit
Interest paid on your personal auto, credit cards, education and other consumer loans is no longer deductible on your tax return.
Interest allocable to business use of property may be deductible. Consult our Controlling Your Taxes article for more information.
In addition, there is only a certain amount of qualified residence (mortgage) interest that is deductible. Qualified residence interest is the interest paid or accrued on acquisition loans or home equity loans with respect to your principal residence and one other residence, usually your "vacation home."
The total amount of acquisition loans is limited to $1 million and the total amount of home equity loans is limited to $100,000. Interest on any debt over these limits is considered to be personal, consumer interest that is not deductible.
Considering Home Equity Loans
Should you convert your consumer loan interest into interest on a home equity loan in order to be able to deduct your interest? Before you join the rush to a home equity loan, you should consider the pluses and minuses.
Category: Personal Finance
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