Parents: Read This Before Co-signing Your Kids’ Student Loans
Money + Markets

Parents: Read This Before Co-signing Your Kids’ Student Loans

flickr/Mira Klein

With the price of college climbing faster than inflation, the amount of money that parents have to borrow to pay for college is also rising. Once they’ve exhausted federal loans (capped at $5,500-$7,500 per year), some students turn to private loans.

While those loans can bridge the gap between a financial aid package and the amount of money a family currently has for college, they come with a serious catch: They typically require a co-signer. It may seem like a no-brainer to parents who want to help their kids attend Dream U to step up to co-sign the debt. A 2012 report by the Consumer Financial Protection Bureau found that more than 90 percent of private student loans required a co-signer, typically a parent or co-parent.

Related: Worried About Student Loans? A New Repayment Plan May Help

Though less than 10 percent of families that borrow for college use private student loans, those who do borrowed an average of more than $12,000 last year, more than twice the amount they borrowed in 2011, according to Salle Mae’s How America Pays for College Report.

Co-signing student loans for your kids, however, can have long-lasting consequences on your financial security. “Parents just want to help their kids pay for college no matter what, but sometimes they don’t realize the financial consequences of doing that,” says Fred Amrein, principal of Amrein Financial in Wynnewood, Pa.

If you’re considering becoming a co-signer for your kids’ loans, here’s what you need to know.

You’re on the hook.
Co-signing on a loan means that you’re fully responsible for the entire debt—it will appear on your credit report. If junior can’t or won’t pay for some reason, the lender will go after you for payments. If you can’t afford to cover the payments, or if taking out the loan will ruin your ability to get a necessary mortgage or car loan, co-signing the loans may not be the best way for your family to borrow money.

Related: It’s Time to Put Student Loan Predators Out of Business

While some private loans allow for “co-signer release,” programs, in which the co-signer can be removed from the loan once the primary borrower has met a certain income threshold and made regular payments, a CFPB report found that 90 percent of consumers who applied for such a release were rejected.

Go with federal loans first
Before looking at private student loans, students should max out any available federal loans, which tend to carry lower interest rates, offer more flexible repayment terms, and don’t require a co-signer. Even if you don’t think your family will qualify for financial aid, you’ll need to fill out the Federal Application for Student Aid in order to qualify for federal loans.

Some families also use Parent PLUS loans to pay for college, which are federal loans in the parents’ name that have many of the same consumer protections as federal student loans.  Even if you plan on having your child make the payments on these loans, there’s no legal obligation for her to do so. The impact on your credit score and debt-to-income ratio is the same as co-signing a loan.

Don’t borrow more than you can afford. Once you’ve exhausted those and are considering private loans, parents should limit their total college borrowing for all children to no more than one year’s income or what they can pay off in either 10 years or before they retire, whichever comes first.

Related: The Court Ruling That Could End the Student Loan Crisis

Consider your child’s projected income as well in order to make a smart choice about whether he’ll be able to cover the payments. Students should aim to borrow no more than their expected first year of salary. “If the student wants to borrow more than that, you might want to look at another school,” says Kal Chany, author of Paying for College without Going Broke.

Before you borrow, find out whether the lender will release you from the loan if your child dies. If not, you should take out life insurance on your child to protect you from the financial impact of such an event.

Have a plan for repayment.
Use this loan payment calculator from FinAid to determine the monthly payments on the loan and to shop around for the best deal. Then sit down with the student to create a mock budget that will illustrate how those payments might impact their ability to do other things like move out or travel with friends immediately after graduation.

Before you co-sign discuss who will be responsible for repaying the loan, and be prepared for tough conversations and choices if s/he can’t afford to make the payments. Unlike federal loans, most private loans do not have a grace period after graduation. So if your child doesn’t land a job immediately or is taking an unpaid internship, you’ll need to be prepared to cover the first few payments.

Related: Pay Off Student Loans or Save for Retirement? Here's What to Do

Kathy Ruby, a college finance expert with admissions consultant College Coach, advises students and parents to set up a joint “buffer account,” in which the student contributes cash, which the loan company automatically debits from the account. (You may also get a small break on the rate for signing up for the auto payment program.) Then you can set up alerts to monitor the account to make sure that there’s enough cash in there to cover upcoming payments, and contribute some cash on your own if necessary so that missed payments don’t ruin your payment.

If your graduate wants to make additional payments on his loans, have him focus on paying down private loans first. That will eliminate your debt obligation sooner and reduce the total amount of interest he pays.