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. While it’s natural for parents to want to help their adult children become homeowners, it may not always be the best decision to co-sign a loan.
We asked John McCafferty, director of financial planning for Edelman Financial Engines in Alexandria, Va., and Chaim Geller, a financial adviser and founder of Help Me Build Credit in Brooklyn, for their advice for parents. Both responded via email and their comments were edited.
A big concern about co-signing is that as a co-signer, the parent has no rights to the property but assumes responsibility for the entire debt, McCafferty wrote.
Q: When should parents consider co-signing a mortgage for their adult children?
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.
Q: Are there some red flags about when it’s a bad idea to co-sign a mortgage?
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.
But there are many reasons assuming this significant responsibility would not be in their best interest, and they should discuss all the variables. For example, what is the career trajectory of the borrower? Is he or she married? If so, what is the spouse’s career trajectory? Do they have children? The list of questions can be lengthy, and there are a number of risks. Meanwhile, the child is leveraging the parent’s financial position to buy something he or she may not be able to afford. For the parent, this creates a higher debt-to-income (DTI) ratio, which could negatively impact their credit score and future borrowing potential. Relationships could also be impacted if any challenges come up with making payments.
Through this lens, I encourage common sense and to not let the family relationship cloud any thinking. 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, etc.? 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.
Q: How does co-signing work? Do parents need to pay anything at closing?
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.
Co-signers complete a residential loan application as part of the process.
After the lender's conditions have been met, the co-signer must agree to all loan terms by signing final loan agreement documents. As the official loan agreement, the note outlines all the loan's most important terms.
If the borrower doesn’t have sufficient funds at closing, the co-signer may need to cover any down payment, closing cost and related additional fees.
Q: Is it a better option to help with the down payment rather than co-sign? Why or why not?
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.
Q: Are there legal steps that protect the parent’s finances and credit?
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.
Some precautions to consider:
1. 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.
2. Review the agreement. This seems obvious, but make sure you know what you’re signing.
3. 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.
4. Collateralize the deal. Set conditions for missed payments. For example, get the second set of keys to their car. Missed payments have penalties.
5. Create your own contract. Create a promissory note that discusses obligations, costs and consequences that the borrower will have if they default.
6. Consider a trust. Work with a legal professional to protect personal assets with the use of a trust.
7. 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.
Q: Any other advice for 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.