Before lending money to someone, a lender may ask for a third party to co-sign or guarantee the loan. Learn how to protect yourself when co-signing or guaranteeing a loan — and how to deal with problems that arise.
When you co-sign a loan, you and the borrower are jointly responsible for the debt. You’re both on the hook for the full amount. If one of you misses a payment, the lender can ask either of you for the money.
When you guarantee a loan, you promise to pay the debt of the borrower if they don’t pay. Before asking you, the lender must first demand payment from the borrower.
In both cases, the lender can come after you if the borrower defaults. But if you co-sign, the lender can come directly to you for payment.
If a lender is nervous about providing a loan, they may ask for a guarantee. This is a promise by another person to pay the debt if the borrower can’t. The borrower is called the “principal debtor.” The person guaranteeing the debt is called the “guarantor.”
As a guarantor, you only become responsible for the debt if the borrower defaults on an obligation. For example, by missing a loan payment. The lender must ask for payment from the principal debtor before coming to you.
Your responsibilities also depend on the type of guarantee you give. There are three types:
Specific or limited guarantee. You agree to be responsible for a certain amount for a certain thing.
Continuing guarantee. You agree to be responsible for a loan (or loans) for as long as the guarantee lasts.
All-accounts guarantee (or unlimited guarantee). You agree to pay whatever the principal debtor owes.
When you co-sign a loan, you and the borrower are now equal owners of the debt. You are joint debtors. If one of you misses a payment, the lender can expect it from the other. And the lender needn’t ask the borrower first. They can come directly to you.
For example, say you co-sign a $5,000 loan for your daughter. You are both responsible for paying back the full amount. If she misses a payment after repaying $1,000, the lender can ask you for the outstanding payments. The lender doesn’t need to ask your daughter first.
Pro tip: Check the loan agreement for an acceleration clause. It lets the lender demand immediate payment of the whole loan if the borrower defaults. So one missed payment could mean the whole loan becomes due.
Step 1. Ask questions before guaranteeing or co-signing a loan
Before putting yourself at risk, ask questions like:
Why does the lender want a co-signer or guarantor?
How high is the risk the borrower will have trouble making payments?
What’ll happen if you don’t sign?
Can you afford to pay off the loan if the borrower can’t?
Step 2. Ask the lender to keep you informed
Ask the lender (in writing) to keep you informed in writing of all activity on the loan. This can help you catch a problem before it’s too late.
Step 3. When the loan is paid off
Once the loan is fully repaid, take steps to end your responsibility. For example, ask the lender to return the original loan document to you. Or ask for a document releasing you from all liability for the debt. This could be a letter of acknowledgment, a copy of the borrower’s discharge, or a release.
In some cases you may not be responsible for a debt if you guarantee or co-sign a loan. For example, a lender (or borrower) can’t use force, fraud, duress or illegal means to get you to sign.
The law allows certain defences for guarantors that aren’t open to co-signers. For example, if the lender and principal debtor make changes to the guarantee that are harmful to the guarantor, the guarantor may not be liable.
Step 2. Negotiate a reduced payment
Say you’ve co-signed or guaranteed a loan, the borrower has defaulted, and the lender is asking you to pay up. What do you do if you can’t afford it? One option is to negotiate a reduced payment. The lender may agree to release you from liability if you pay a portion of the loan.
Step 3. Negotiate to limit your liability
Consider negotiating with the lender to limit your liability for the loan. For example, the lender may agree to release you from responsibility if:
someone else is willing to replace you as co-signer or guarantor
the borrower has already repaid most of the loan
there are enough other co-signers or guarantors to satisfy the lender
Step 4. Make an agreement with the other borrower
As a guarantor or co-signer, you can make a separate contract with the other borrower. In it, you can set out what happens in the event of a default. For example, you could say that the other borrower must reimburse you for any payments you make if they default. This is called “indemnifying” you.