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Cosign or lend?

July 03, 2014

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

savings accounts

Q: A friend of mine has had some financial problems in the past, but now has a good-paying job and has gotten his budget under control. He needs a car loan but is having trouble qualifying because of his past history. He asked me if I would lend him the money myself or cosign a loan with him. Which do you think would be better?

A: Ugh. Your friend is putting you on the spot by offering you a choice of two unappealing options.

If you cosign a loan, you are agreeing to be fully responsible for the loan if your friend defaults. So, you could be out the amount borrowed, plus any interest and penalties resulting from late payments. Beyond that potential cost, your credit rating could be affected simply by taking on this obligation, and it would certainly be affected if your friend defaults and you have trouble paying back the loan.

In contrast, there are a couple of advantages to lending him the money yourself as opposed to co-signing a loan. Both put you in the position of potentially losing the principal of the loan, but at least if you made the loan yourself, you would not be on the hook for any interest or penalties. In fact, a potential upside is that you would presumably be charging your friend interest, and with interest on savings accounts and other deposits near zero, this could be a way of earning a little more on your money -- if everything works out.

Of course, personal loans are also much more risky than savings accounts, so you should take that into consideration when deciding what interest rate to charge your friend. Basically, his inability to qualify for a loan on his own tells you that lenders consider him a high risk, and friendship or no friendship, you should view him the same way. You should charge an interest rate that takes into account the amount of risk you are taking.

If you decide to make the loan, you should set up a formal loan agreement and payment schedule. This should not be treated casually because you are friends. In fact, one potential problem of making the loan yourself is that your friend might take an obligation to a professional lender more seriously, while he might be tempted to try to appeal to your friendship if he has trouble making payments to you.

Of course, there is a third option here: just saying no. You mention that your friend is getting beyond his past financial problems, but part of becoming financially responsible is accepting the consequences for past mistakes. Your friend may just have to wait and save up for his car.

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