Cosigning a loan, especially one for a home mortgage, can be a risky business for both parties. It’s like any other business deal with a relative: there are financial and emotional risks to be considered.
Here’s an example of two well-meaning family members: an individual who is in good shape financially but because he is self-employed, is getting turned down for a mortgage without a co-signer, and the second, a relative who is willing to cosign a mortgage. What could go wrong?
Let’s say the family member has a good job but won’t be contributing any money toward the down payment or mortgage payments. The buyer plans on setting up a separate shared bank account that would cover at least a year to 18 months of expenses for the home, in case something happens to him. Therefore, the relative won’t be burdened. The buyer will also list that person as a beneficiary on the mortgage. This allows them to sell the house or live in it.
The Los Angeles Times, in its recent article, “How cosigning a mortgage loan can bring big risks,” looks at the pros and cons of cosigning a loan for both people. Some of the issues to consider include the following with a cosigner:
- What’s the tax liability?
- What if the relative lives there and pays the buyer rent?
- What if the buyer refinances in the future to remove the cosigner?
- What about a revocable living trust? Is that a better option?
Inheritance. If the buyer wants the relative to inherit the house if he dies, he could include her as the property’s beneficiary in his estate plan or a transfer on death deed. It is important to remember that mortgages aren’t assets, so they don’t have beneficiaries. If the cosigning relative inherits the house, she typically wouldn’t owe taxes, provided the home isn’t in one of the six states that still has an inheritance tax (Iowa, Kentucky, Maryland, Nebraska, New Jersey, or Pennsylvania). Those six states have laws that permit closer relatives to usually pay lower taxes than more distant relatives or unrelated friends.
Leaving Money for the Relative. The buyer also could leave money to pay the home’s expenses for a specific time. This is a better notion than a shared bank account (unless the relative insists on access as a condition of the loan). It’s best to minimize financial entanglements with people, if you’re not married to them or legally or morally responsible for them.
Refinancing. Refinancing the loan should be a priority, instead of leaving the relative the loan or inviting her to be a tenant. A landlord-tenant relationship makes for a more complicated situation, and a relative could be tough to evict.
Both the buyer and the prospective cosigning relative should speak with their estate planning attorneys to ensure that the short and long term arrangements will not have a negative impact on either of their finances or the estate plan. The potential for problems will be significantly lessened with proper planning.
Reference: Los Angeles Times (July 30, 2017) “How cosigning a mortgage loan can bring big risks”