Co-Borrowers

Co-Borrowers

One or more persons who have signed the note and are equally responsible for repaying the loan.

When One Co-Borrower Has Much Better Credit than the Other: A problem that arises frequently with co-borrowers is that one has much better credit than the other. If they buy the house together as co-owners and co-borrowers, the deadbeat's bad credit will result in a bad credit rating for the transaction and a corresponding high interest rate.

One option is for “good-credit” to buy the house alone, leaving “bad-credit” out of the deal. But then the mortgage would be limited to the amount that the income of “good-credit” can support. Whether this option works depends on whether the mortgage that “goodcredit” can carry, plus the down payment the partners can make, permit them to purchase the house that they want. See Affordability/Calculating the Maximum Affordable Sale Price.

Still another possibility is to have a third party with good credit and income replace “bad-credit” as the co-borrower. Usually only a parent would be willing to play this role.

When Co-Borrowers Split: Problems can arise when co-borrowers split, whether they are married or not. However, difficulties seem to arise more frequently with unmarried couples, perhaps because unmarried couples purchasing a house together more often do it blindly. When they split, issues that should have been foreseen, but weren't, may prevent a clean and amicable separation.

Here are the major issues to resolve with your partner before you buy.

Split with Sale: There is much to be said for an agreement that the house must be sold if either partner aborts the relationship. This avoids the thorny issues, discussed below, that can arise when one partner stays with the house.

If a split leads to a sale, the only issue is how the proceeds are to be divided. Equal shares may or may not be equitable. A partner who pays the down payment, or a larger share of current expenses, deserves a larger share of the proceeds.

One approach is to divide the net proceeds by each partner's contribution to the equity in the house when it is sold. Suppose, for
example, that the partners pay $100,000 for a house, take a mortgage of $80,000, pay $20,000 down plus $3,000 in settlement costs, and sell it after five years when the loan balance is $74,000. Total contributions of the partners to equity in the house at the time of sale consist of $23,000 in cash at purchase, plus $6,000 in reducing the loan balance. If one partner contributed 60% of the cash and paid 40% of the expenses, that partner's share of net proceeds would be [.6($23,000) + .4($6,000)]/ $29,000, or 56%.

In some cases, this rule would not be fair. For example, one of the partners might unilaterally work on improving the house, which would call for a higher share.

The point is that the partners ought to agree at the outset on the terms of the split. If they can't agree, they should reconsider whether they really want to cohabit.

Split with One Partner Staying: The terms of settlement are more complex when one of the partners remains in the house. There is no sale price, so the partners must agree on an appraisal procedure and on who will pay for it. They should also agree on whether a real estate sales commission should be deducted from the valuation used in the settlement. If they wait until the event, this is invariably contentious.

Another problem arises if the partner remaining in the house doesn't have the money to pay off the partner who is leaving. The
more equity they have in the house, the more cash the resident partner needs to raise. A home equity loan is not possible unless both partners become responsible, which is the last thing the departing partner wants.

The largest problem, however, is the departing partner's continuing responsibility for the mortgage. Many departing partners believe that they are off the hook because the partner remaining in the house has agreed to assume full responsibility for the mortgage. They (and often their lawyers) overlook the fact that the lender was not a partner to their agreement.

As far as the lender is concerned, the departing partner remains liable. If the departing partner seeks to purchase another house, the old mortgage will show up on his or her credit report, reducing the size of the loan for which he or she can qualify.

Lenders have no incentive to remove one partner from the note. Some can be induced to do it if the partner remaining with the house has a perfect payment record and can document that he or she has been solely responsible for the payments. But in the best situation this takes time, perhaps a year.

If the lender refuses, the only way to get the departing partner off the note is for the remaining partner to refinance in his or her own name. But if this was not part of the original agreement, it is unlikely that the remaining partner will agree later—unless refinancing becomes financially advantageous at the time.

If both the original lender and the remaining partner refuse to help, a new lender may be willing to ignore the old mortgage obligation if presented with evidence that the remaining partner has been meeting the payment obligations. Unlike the old lender, a new lender has something to gain by wiping the departing partner's slate clean.

Of course, if the remaining partner has not been making payments on time, neither lender will be willing to help the departing partner.

If I were drafting an agreement for a loved one, not knowing whether he or she was more likely to be the remaining or the
departing partner, it would grant the remaining partner 14 months to make the settlement payment and to remove the departing partner from the note. Otherwise, the house must be sold and the mortgage paid off.