Sometimes we need to help the people in our lives. While we all know the financial risks, cosigning can help a child, friend, or loved one secure the loans they need for housing, transportation, or even to help launch a business.
There are many reasons that people cosign for others, but unfortunately, it can sometimes end poorly. One of the consequences of cosigning is that the debt amount can be added to your debt-to-income (DTI) ratio. For example, if you cosign for a daughter’s car loan with a $200 monthly payment, that $200 could be factored into your monthly debts, even though your daughter makes the payment. This $200 could put you over the top of a lender’s allowable DTI.
Suddenly, your good deed keeps you from getting the loan you deserve!
Fortunately, there are new guidelines, as well as a few steps you can take, that increase your chances of mortgage approval by excluding debt that is paid by others…
Excluding Debt Paid By Others
How Cosigning Affects Borrowing Power
When you cosign for a loan, you are effectively guaranteeing the loan against default. The lender now has the legal right to seek payment or compensation from you if the primary borrower is unable to make the payments.
Look at it from a lender’s perspective. Let’s say you write a loan to a borrower who has cosigned on a home for their children. What happens if the child’s home goes into default? Your borrower would suddenly be financially responsible for the mortgage on their child’s home, which could create difficulty when it comes time to pay your loan.
Although a borrower may not be making payments, having a cosign attached to their name creates risk for the lender. For this reason, it has been harder for lenders to approve loans for someone who has cosigned for another. They may not be making the payments, but the increased risk could give lenders pause.
Contingent Liabilities Open Doors to Some Borrowers
In the past, lenders had to work significantly hard to qualify a borrower with a cosign obligation, usually because the debts, even if they were paid by the primary borrower, were included on the cosigner’s debt-to-income ratio, an important factor for measuring a person’s risk. Lenders would have to get copies of the original note, and verify that the potential borrower was only a second signature. The lender would also need evidence from the primary borrower that payments were being made over the past 12 months. Unfortunately, some applicants may be denied because a cosign increases their debt-to-income ratio, but Fannie Mae has taken steps to alleviate this issue.
Back in October of 2017, Freddie Mac announced new guidelines, which are now standard, for situations that involve contingent liabilities. “Contingent liability” is simply a financial responsibility (aka liability) that only occurs if a certain situation occurs. (It is “contingent” on a situation where the primary borrower being unable to pay.)
The new guidelines included many details, but the most important part says that if you take out a loan that someone else is paying, this debt can be excluded from your debt-to-income ratio under certain circumstances. This means that many borrowers will now be eligible for financing, even if they have cosigned for another person’s debt.
The new guidelines apply to many different areas, including situations where someone else pays the debt even if their name is not attached. For example, if you are a college student with a car loan attached to your name, but your parents are making the payments, this can be excluded from your debt-to-income ratio. This could be important if you are applying for a condo mortgage near your college, for example. To remove the car loan from your debt-to-income ratio, you will have to prove 12 months of payments from the other person; if the car loan is less than 12 months old, unfortunately it cannot be excluded from your application.
Installment loans can also be excluded from your loan application. Most lenders will actually allow installment loans to be excluded, but some will not allow this to occur; make sure to talk with your lender to fully understand their options.
Excluding a business loan that is paid by another person is a bit more tricky, and in many cases it comes down to the discretion of the lender. If you need to omit a business loan from your debt-to-income ratio, remember that is is often faster to prove the installment loan is paid by a business due to the fixed amount. Revolving debts, however, have revolving payments, so proving where payments have come from is more complex. In this case, proper documentation is the key. To have the debts excluded, you’ll need to bring 12 months of cancelled checks from a business account, banks statements that source the funds, and account reports that show the debt as a business account. This last document can be helpful for proving that the debts are technically paid by the business, and legally attached to the business, not by you.
Something to Consider: Co-Borrowing Instead of Cosigning
One option that we’d like to mention is the option of co-borrowing instead of cosigning. When you cosign, you essentially attach your financial assets to a loan without the benefits of ownership. For example, if you cosign on a car loan and the first borrower can’t pay, you tytpically can’t take ownership of the car, even though the lender can take ownership of your money in order to get compensated!
If you co-borrow, you may reduce your financial risk, as the property in question is part yours, so you have some of the benefits of ownership. You still take the financial risks, but you at least have ownership rights if the situation ends badly.
Helping You Achieve Affordable Homeownership!
If you want more advice on mortgage approval, contact the team at San Diego Purchase Loans today. We’ll make sure you understand the details of each loan product, as well as your options for loan approval, so you can make the best choice for your future!
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