What are Surety Contracts?
A surety contract is a legally binding agreement that the signee will accept responsibility for another individual's contractual obligations, usually the payment of a loan if the principal borrower falls behind or defaults. The person who signs this type of contract is more commonly referred to as a cosigner. While common law historically has distinguished cosigners (those who sign surety contracts) from guarantors, U.S. law makes the two terms virtually identical.
Someone may sign a surety contract to help their child obtain a car loan, to start a business, or some other transaction considered by the lender to be relatively high-risk. In many lending situations, it is a requirement for getting the loan or, alternatively, can help the borrower get a better rate.
Surety Contracts and Risk
Surety contracts are intended to minimize the risk to the lender, who would rather not spend money on collection agencies or lawyers to secure the repayment of a loan if the borrower defaults. But, anyone who is asked to cosign a loan should fully understand their risk, should the loan go unpaid. Nearly three out of four cosigners end up repaying the principal borrower's loan, according to research cited by the Federal Trade Commission (FTC).
Here's another way of looking at it: The reason a borrower asks a friend or a parent to cosign a loan is because the lender would not otherwise give this person the loan.
Federal law requires lenders to provide surety contract signees with the following language, referred to as the cosigner's notice:
You are being asked to guarantee this debt. Think carefully before you do. If the borrower does not pay the debt, you will have to. Be sure you can afford to pay if you have to, and that you want to accept this responsibility.
You may have to pay up to the full amount of the debt if the borrower does not pay. You may also have to pay late fees or collection costs, which increase this amount.
The creditor can collect this debt from you without first trying to collect from the borrower. The creditor can use the same collection methods against you that can be used against the borrower, such as suing you, garnishing your wages, etc. If this debt is ever in default, that fact may become a part of your credit record.
This notice is not the contract that makes you liable for the debt.
If You Do Cosign a Loan
The FTC offers the following advice for individuals who have agreed to sign a surety contract:
- Make sure you can afford to repay the loan (otherwise, you could be sued or have your credit rating damaged).
- Understand how your liability for someone else's loan can hurt your ability to get other credit, even if you are not asked to repay the debt (since it will be included on your credit report).
- Make sure you are willing to relinquish a given piece of property used to secure a loan, such as a car.
- Find out how much money you might owe should the borrower default, since it could include late fees, court costs, or legal fees (in some cases, you can limit your liability to just the principal balance of the loan).
- Ask for written notification if the borrower is late with a payment.
- Keep copies of the important loan documents.
- Check state law for any additional cosigner rights that may apply.
Signing a surety contract is not always in the best interests of the cosigner, but risks can be mitigated with proper preparation.