Hidden risks on some student loans

It doesn’t always pay for young borrowers to add parents, grandparents or other relatives as co-signers to get a lower interest rate on a student loan from a bank.

In some cases, when the co-signer dies or falls into bankruptcy, the action may trigger an automatic default. When that happens, lenders can demand that the full amount of the loan be paid immediately by the young and likely cash-strapped borrower — even if loan payments have been made like clockwork.

The result is a potentially huge red flag on a young borrower’s credit rating, making it difficult and more costly to obtain a loan down the road. It could even be a turnoff for a potential employer.

The federal Consumer Financial Protection Bureau laid out these scenarios in a new report on automatic default provisions embedded in private student loans. The consumer agency said it has received a growing number of complaints about private lenders demanding accelerated repayments when the co-signer dies or files for bankruptcy.

The vast majority of private student loans have a co-signer, according to the report. Co-signers are typically able to reduce the interest rate on the loan because students often don’t have a credit history.

But what’s sometimes not understood is that the co-signer is also on the hook for the loan. As a result, changes in the co-signer’s financial status can impact the loan, cause a default and trigger a demand for paying the entire balance due, the consumer agency said.

While the watchdog agency said there is nothing illegal about the practice, it urged lenders to give borrowers more time to find a new co-signer. It also suggested providing more transparency about automatic default clauses in the loan documents.

The consumer protection bureau has sample letters on its website (

) on how to obtain a release from a co-signing agreement.

There are other ways to fine-tune this borrowing strategy, said Mark Kantrowitz, a national expert on student loans and publisher of Edvisors, a financial aid website.

Kantrowitz said he has never seen instances of borrowers facing defaults because their co-signer died or filed for bankruptcy.

Rather, he said, the real issue that needs addressing is the challenge that borrowers face in qualifying for a release from a co-signed loan.

“Borrowers report that it is very diffcult to qualify for a co-signer release,” Kantrowitz said. “Lenders are very strict because they are concerned the borrower will default after the co-signer is released from the obligation.”

To increase the chances of a young borrower qualifying for a co-signer release, Kantrowitz listed some of the standards that must be met:

• All payments must be made by the borrower, not the co-signer. Lenders track who made the payments.

• In the event the borrower is no longer in school, he or she must have a stable job with sufficient income to be making the loan payments.

• All the payments must be made in full and on time. Kantrowitz recommends that borrowers sign up to have their loan payment automatically deducted from a bank account.

“A single late payment is enough for the borrower to lose eligibility” for a co-signer release, he said.

• The borrower must have a very good credit score.

Another downside protection step: Refinance the loan without a co-signer, Kantrowitz said.

Sure, lenders can and should do a better job of spelling out repayment terms and posting co-signer release forms on their websites or in their offices. Ultimately, it’s still the young borrowers’ responsibility to know what they’re signing on all types of loans — not just student loans.