Most parents want to help their kids – it’s part of being a mom or dad. As the children grow into adulthood, that desire to provide parental assistance remains high, but parents need to be cautious. The older your kids get, the greater the consequences of their financial decisions, and the higher the likelihood that your financial assistance might backfire.
This Washington Post column from last May provides a good illustration of the danger posed by good parental intentions. Columnist Michele Lerner investigated the pitfalls that can befall parents who co-sign home loans for their kids, and her conclusion – verified in her Q&A with two financial experts – is that mom and dad’s desire to help can prove to be a very bad decision, not only bringing financial damage but relational damage as well.
Good Intentions Can Lead to Bad Decisions
Writing in the Washington Post, Lerner begins, “Rising home prices and higher mortgage rates are reducing affordability for many first-time home buyers. Rather than give up their dream of buying a home, some people are turning to their parents for help with down payments or to co-sign their mortgage.” But experts advise caution. “While it’s natural for parents to want to help their adult children become homeowners,” Lerner warns, “it may not always be the best decision to co-sign a loan.”
In order to get a balanced and well-rounded view of the issue, Lerner asked John McCafferty of Edelman Financial Engines and Chaim Geller of Help Me Build Credit to share their thoughts with parents considering this decision. As Lerner points out, interview responses were sent via email and edited, but for the sake of our AgingOptions blog readers we’ve edited down the quotes even further to highlight the important points, and we’ve added comments of our own. We highly recommend checking out the original article for the full unabridged interview.
When Parents Should Say “Yes” to Co-Signing
Both of the financial planners consulted for the Washington Post article agree: parents should only agree to co-sign when that decision does not cause potential damage to their own financial situation. As one planner said, failure to show proper caution can be “devastating.”
McCafferty: “Parents get involved when an adult child is not in the financial position to qualify for a mortgage on their own. There are pros and cons to being a co-signer. I would only suggest a parent move forward if it is very clear that their own financial health — such as their retirement security — will not be compromised.”
Geller: “Co-signing is one of the biggest favors a person can do for their child. But co-signing is not meant for everyone. To ensure that you’re not going to regret it, you need to understand the seriousness of co-signing. It needs to make financial sense, and you need to have the proper confidence in your kid. If you don’t, then co-signing can be a devastating mistake, which can have severe consequences. It can ruin you financially, mess up your credit, and the worst — cause a rift in your relationship.”
Before Co-Signing, Pay Attention to Red Flags
In their conversations with Lerner of the Washington Post, McCafferty and Geller, both advise parents to watch for danger signs.
McCafferty: “Yes, the fact that co-signing is required is a red flag, and it should at least prompt the parties involved to ask, ‘Why is co-signing necessary?’ While the answer may be evident, going through the vetting process is important. There may be an expectation that mom and dad must help, especially if they’ve taken care of most other financial obligations up to this point.”
McCafferty goes on to explain that parents should always consider the variables and risks associated with making this leap. Career trajectory, marriage status, children – all can have an effect on the parent’s debt-to-income ratio, which can be a net negative for the parents’ credit score and borrowing potential in the future. This could, in turn, impact the relationship between child and parent.
He concludes, “The critical question I pose to clients is this — would you agree to this type of arrangement if your child wasn’t involved?”
Geller: “Young adults can often have unrealistic dreams, and your kids may dream of buying a home that they can’t afford. Before you co-sign for your kids, sit down with them and discuss their finances. What is their income? What are their monthly expenses? How much do they spend on groceries, restaurants, etcetera? Do they have monthly car payments? That should help you see if you feel comfortable the mortgage is affordable for them. Leave some financial breathing room for unexpected expenses. If you feel that they are overextending themselves and you’re afraid they will not be able to afford the mortgage payments, then politely explain that you recommend them to find a more affordable home, or else they can count you out from co-signing.”
Know the Details: The Mechanics of Co-Signing
Both planners warn that failure to understand what co-signing actually is and what it entails can lead parents to make naïve decisions. Parents need to know what they’re getting into.
McCafferty: “A co-signer helps a borrower qualify for a mortgage by agreeing to pay back the loan if the borrower stops making payments. As a co-signer, you don’t have an ownership stake in the home and your name doesn’t appear on the property title. An ideal co-signer will have plenty of income, an excellent credit score and a healthy debt-to-income ratio.”
The process summarized goes like this: A residential loan application is required of all co-signers in the process. After all of the conditions put forward by the lender have been met, the co-signer must sign the final loan agreement documents, agreeing to all of the terms. The co-signer is then on the hook to cover any insufficient funds on the borrower’s behalf, like the down payment, closing cost, and other fees.
Is it Better to Help with the Down Payment?
In their Washington Post interview, both men were asked if there’s a better, less dangerous alternative to co-signing. For example, should parents agree to help with their kids’ down payment on a house?
McCafferty: “This is a more prudent approach — as long as the parent’s financial health is not compromised. The main reason is that the risk is limited to the amount of money offered up and the parent’s liquidity to supply it. This approach can be a win-win for all parties. The parents satisfy the need to help while the family member gets to become a homeowner.”
Geller: “In some cases that will work better as you’re not going to be tied to the loan for the next 30 or so years. On the other hand, if your kid is not mortgage eligible without you co-signing then paying part of the down payment will not help them.”
How Parents Can Protect Themselves Financially
McCafferty: “Generally, the only way the co-signer can get their name off the loan is if the borrower refinances. Remember, a mortgage is a contract. Once it’s signed, it’s tough to undo.”
We’ve included McCafferty offered seven tips for parents. We’re quoting them verbatim because we feel they’re very useful.
- Act like a bank. Establish criteria for the borrower you are helping. For example, examine their credit report or ask about their job situation, or review their monthly expense.
- Review the agreement. This seems obvious, but make sure you know what you’re signing.
- Be the primary holder (not secondary). This will give you more control. Statements will go to you. You can then collect from the secondary borrower.
- Collateralize the deal. Set conditions for missed payments. For example, get the second set of keys to their car. Missed payments have penalties.
- Create your own contract. Create a promissory note that discusses obligations, costs and consequences that the borrower will have if they default.
- Consider a trust. Work with a legal professional to protect personal assets with the use of a trust.
- Establish an exit strategy. For example, 12 to 24 months may be suitable. At that point a refinance should occur. Set proper expectations at the beginning.
Geller: “There are two things I recommend. One is to sign an agreement with your child that your child agrees to refinance the mortgage loan as soon as they become mortgage eligible and remove you from being a co-signer. This will ensure that you’re not tied to the loan longer than necessary. Secondly, I highly recommend requesting the bank to mail mortgage statements to your address as well. Banks usually only send mortgage statements to a co-signer if the co-signer requests them explicitly. For you to be able to properly be on top of the loan and make sure the payments are made on-time, be sure to request to receive monthly statements and review them every month.”
Experts Offer Summary Advice
Lerner of the Washington Post asked each expert to sum up his advice to parents.
McCafferty: “It’s understandable when a parent wants to help their children — especially in the current real estate market. If you work with a financial planner or wealth adviser, include them in the process. They can offer relevant experience and objective perspective. In the end, understand the monthly payment obligations and whether they can be comfortably met by the borrower. Most important — use common sense and don’t allow a family member to get in over their head.”
Geller: “In some cases, you’re better off saying “no” to co-signing. I know a few cases of close family members who are not on talking terms because of a co-signing going sour down the road. So sometimes the best thing you can do for your relationship with your kid is saying “no” to co-signing. It will be better for you and for your kid.”
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(originally reported at www.washingtonport.com)