Photo: Flickr / Im Kelsi
Credit: It seems you need it for everything these days. That’s probably why so many well-intentioned parents are co-signing loans for their kids. There are some good reasons why people decide to become a co-signer for their kids, including helping them to buy a car or first home, or to establish a credit history.But while you may be aiming to do well by your children, co-signing can have huge financial consequences — and not just for you. Here’s why you should never co-sign loans for your kids.
Your Credit, Your Risk
Here’s how co-signing works: If someone with no credit history requires a loan, the bank may be unable to deliver — after all, they have no idea how much risk there is that a credit neophyte won’t pay back the money. This is where the co-signer comes in, essentially vouching for the potential borrower based on his or her own credit history.
The bank always wants to have someone on the hook in case the loan is not repaid. If you co-sign a loan, that person is you. What this means is that if your son or daughter doesn’t pay up, you will be expected to do so, or risk suffering the impact of a default on your credit score. Plus, that loan is considered part of your credit history, which means it can affect how much you’ll be able to borrow yourself.
Too Much Risk for the Bank Means Too Much Risk
Lenders have some pretty 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 anauto loan, for example, they may have a point.Whether your child has poor credit or no credit, both are signs of a lack of experience with borrowing money.
According to the Federal Trade Commission, as many as three out of four primary borrowers default on a co-signed loan, leaving the co-signer with the bill. If the bank believes the risk is too great, maybe you should consider whether this is a risk you should be bearing.
You’ll Have to Bail Them Out
If your goal is to teach your kids about how to use credit responsibly, co-signing on a loan may not be the way to go. If that emergency credit card is used to pay for a trip to Cancun over spring break, you will have no choice but to foot the bill or face the consequences to your credit score.
There are many risks and few co-signer rights. If you co-sign a loan, whatever it is used to pay for belongs to your child, but the responsibility to pay for it is yours. Unfortunately, a scenario in which you are forced to swoop to your children’s rescue every time they use poor financial judgment is not much of a reflection of the real world. In the future, they’ll be expected to atone for their own financial blunders and debt collectors will hound them directly.
Building Credit Is Learning Credit
The drawback to not co-signing a loan for your kids is that it will take longer for them to start building their own credit. This has become a greater concern since the Credit CARD Act made it much harder for those under of the age of 21 to open a credit card. Unfortunately, the reason why this provision of the act was introduced in the first place 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 here is not such a bad thing. After all, it makes a lot more sense for kids to get their first credit card after securing their own source of income. This way, they will learn how credit really works and what it takes to pay it off. Yes, they will inevitably make some poor financial decisions, but this is the best way to learn how credit really works.
No Credit, No Big Deal
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 what can be either a tool or a credit killer.
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 develop a solid FICO rating on their own some day.
What to Do Instead
If one of your children is facing a tough financial situation, turning down a request to co-sign a loan doesn’t necessarily mean hanging them out to dry. One of the best alternatives is to lend money to your child directly. After all, this is essentially what you’re doing when you co-sign, except that a personal loan will protect your credit if the loan is not repaid.
You could also lend your child $500 to help them get a secured credit card, or “seed capital” to put toward financial goals on their own. If your child wants a nice car, shell out $500 for an old car that’ll get them to and from work. If debt’s already a problem, offer to pay for a visit with a financial planner or debt counselor who can help them build the skills they need to get out of debt and stay out for good. Whatever you do, make sure it involves making your kids work for what they want — and feel the sting of poor financial decisions.
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 may be missing the point. There’s plenty of time to build a credit score, but helping your kids do it may not help them learn what it takes to manage credit and, most importantly, how to live without it.