The Little-Known Student Loan Bait & Switch

Ever been promised something with a couple of strings attached, only to have more and more added the closer you got to your goal?

That appears to be what co-signers of private student loans are experiencing, at least according to the mid-year update from the Consumer Financial Protection Bureau (CFPB). Family members who agreed to be held contingently liable for the loans their children and grandchildren undertook were told they would be released from their contractual obligations after a certain number of prompt payments. Only later did they learn that they would remain on the hook for months and, sometimes, years more.

Complaints about this are rampant. Not only do the extensions of co-signer commitments appear to be arbitrarily determined, but there are also reports of absurdly cumbersome paperwork and unspecified or unilaterally modified credit-underwriting requirements. Worse yet, loans have been automatically placed into default and aggressive legal actions taken when co-signers have passed away or declared bankruptcy – even if the borrower is current on the loan.

In its purest form, the fundamental thinking behind co-signed debt is straightforward. The primary borrower lacks sufficient credit history, acceptable past-payment performance or adequate cash flow to assure the repayment of the loan that’s under consideration. So the lender conditions its approval on the creditworthiness of a back-up borrower, who would be called upon to make good on that debt should the primary borrower fail to make the payments.

What appears to have happened, however, is that instead of requiring co-signers as a last resort, private education lenders now routinely lead with that stipulation. In fact, as more financial institutions jump into the student-loan refinancing pool, co-obligation is an advertised prerequisite.

Workable Solutions – Or Not?

All this taken into account, the CFPB makes three suggestions at the conclusion of its report. To start, the bureau would like to see the loan servicers take the time following the death of a co-signer to determine whether the primary borrower is now able to meet his or her obligations without the added support of a replacement co-signer. If not, then perhaps the primary borrower can convince a deceased person’s spouse or some other family member to step into the original co-signer’s shoes. And, if all else fails, the bureau would like to see the lenders grant to the primary borrower additional time to refinance his or her loan with another lender.

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As sensible and well-intentioned as these suggestions sound, they are, unfortunately, naïve, for a simple reason: Neither the CFPB nor the borrowers nor the co-signers have any negotiating leverage.

Releases of co-obligation, re-evaluations of creditworthiness and waivers of so-called events of default all track back to the terms and conditions that are part and parcel of a contract all the parties—including the lender—consented to upfront. Consequently, all of them would have to agree to modify those same terms in order to carry out the bureau’s recommendations. Moreover, unless the lenders (or subsequent note holders, when the loans are sold to others) have formally delegated credit-underwriting responsibilities and documentation modification authorities to their subcontracted loan servicers, the servicers will not be in a position to release or replace any co-signer. In fact, it’s even possible that the lender could end up with two co-signers, unless the first is released as soon as the second comes aboard.

As for the suggestion that the lender give the borrower more time to refinance his loan, let’s take a moment to ponder that. If the borrower doesn’t have what it takes to qualify for standalone credit with his current lender, how likely is it that he will be able to accomplish that with an institution that doesn’t know him?

What Borrowers Can Do

The vast majority of private student loans that have gone “live” are co-signed. Unless Congress decides to right these wrongs, all that any borrower or co-signer who finds himself in this type of predicament can hope for is to negotiate the most favorable outcome the lender is willing to concede.

Going forward, however, prospective private student borrowers who are compelled to deliver loan co-signers in exchange for the financing they want would be wise to demand four concessions.

Justify the need. Many private lenders appear to have adopted a stance that all loans require co-signers and that the applications must include this additional credit-background information in order to be processed. Prospective borrowers should instead insist that lenders first evaluate their creditworthiness on a stand-alone basis. I’ve heard from college grads who’ve established themselves in their chosen careers and are now contemplating refinancing their student loans: all were asked for co-signers even before the lenders reviewed their initial applications. So they pushed back—hard—and the lenders yielded.

Limit the term. When there is a legitimate need for a co-signer, it’s important to cap the duration. Three years is a reasonable amount of time for a new borrower to begin to settle into a career and build credit. Therefore, it makes sense to negotiate for a coincidental sunset on the co-signer’s obligation. As for the typical requirement of lenders for prompt payments during those first three years, negotiate for the insertion of the word “reasonably” before “prompt.” Student borrowers are financial neophytes: They’re more likely than most to trip up at first—not because they lack the cash, but because they’re new to the process. As long as their missteps aren’t chronic, lenders should be willing to cut them some slack. Accordingly, “prompt” should be defined in the contract as “less than 30 days past due.”

Re-justify the need when conditions change. In the event that a co-signer dies or encounters irresolvable financial difficulties before that third anniversary, the borrower’s credit standing should be re-evaluated before any other action is taken. The basis for that re-evaluation—such as minimum acceptable FICO scores and maximum acceptable levels of debt to income—needs to be spelled out upfront.

Ensure the release. As soon as the third anniversary is reached—or if a co-signer is to be released for other reasons—it is important that the loan documentation provide for the immediate and unconditional termination of his or her contingent obligation.

Whether it’s because borrowers and their families are typically inexperienced in these matters, or that they felt they had no other choice at the time (Federal Direct Loans are a better option), it’s obvious that the private student-lending industry has gotten the better part of the bargain for a long time.

The question is: Have education borrowers finally reached the point where enough is enough?

[Editor’s Note: If you’d like to refinance your student loans or get a co-signer off of your current loan, it’s important to work on your credit. You can track two of your credit scores for free every month and get a personalized action plan on Credit.com.]

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.