During the "farm financial crisis" of the 1980's, an estimated 200,000 to 300,000 U.S. commercial farmers went out of business. Most of these were young, highly leveraged operators who lacked the equity reserves to withstand the combination of low commodity prices, high interest rates and falling land values. Often their parents and sometimes their grandparents also lost everything because they had loaned their children or grandchildren money, co-signed notes and/or sold them property with existing debt. One lesson from these experiences is that parents should structure transfers in ways that will avoid continuing financial responsibility for their children's debts.
Be wary of providing financing for the buyer of property, even if the buyer is your child. If the buyer defaults, a major source of retirement income could be interrupted or lost. Also, mortgages, land contracts and other personal loans are illiquid; and they typically have fixed interest rates that offer no protection against inflation. Whenever possible, the children should get financing from a financial institution or other third party.
Children whose credit rating is questionable usually must have a cosigner on their loans. Borrowers usually ask their parents, other relatives or close friends to cosign their notes. Cosigners do not always assume the same liability as the primary borrower, but they always assume some liability.
If a person cosigns with the borrower in the lower right corner of the note, the law regards that person as a comaker. If a parent is a comaker on a note with a child and property solely owned by the child is pledged as security, the parent is fully liable for repayment of the loan.
This includes any deficiency outstanding after foreclosure and disposition of the security. The lender can collect from the parent if the child defaults on the loan. However, the parent can legally collect reimbursement from the child for only half the amount paid. In cases of foreclosure, lenders must notify comakers before selling property securing the loan. Failure to notify ends the comaker's liability for any deficiency remaining after selling the collateral.
A person who signs an instrument to lend their name to another party is an accommodation party. By definition, then, a cosigner is an accommodation party. An accommodation party is a surety. A surety agrees that the lender will not have a loss if the borrower defaults. Unlike a comaker, a surety who pays the lender is legally entitled to full reimbursement from the borrower. Moreover, a surety may choose not to pay the lender but may choose to bring action against the delinquent borrower. Any change in the original loan agreement, such as an increase in the amount of the loan or the maturity date, without the consent of the surety, releases the surety from all liability.
An area of conflict between cosigners and lenders is whether a cosigner is an accommodation party or a comaker. Information used to resolve these conflicts includes: 1) the location of the signature on the note, 2) the language of the note itself, 3) whether the cosigner received any proceeds of the loan and 4) the intent of the parties when they signed the note.
A guarantor is a person who promises to answer for the debt or default of a third party. In Ohio a guarantor is a surety and has the statutory and common law rights and obligations discussed above under Accommodation Party.
The contract between the creditor and the guarantor is separate and distinct from the contract between the creditor and the borrower. A general or absolute guarantor guarantees payment to the creditor on the same terms as the principal debtor.
A conditional or limited guarantor does not necessarily become liable when the principal borrower defaults. The creditor must meet all conditions specified in the contract between the creditor and the guarantor before the guarantor becomes liable.
If parents must cosign loans to ease the transfer of property to their children, they should do so as accommodation parties, or limited guarantors, not as comakers. They should carefully explain their status of surety in the note. In addition, the parent should sign the note as "John Doe, Surety" to clarify the status of accommodation party.
The parents' attorney should carefully word conditional or limited guarantor contracts to limit their liability as far as duration and/or amounts of money. Even so, parents should recognize that their legal rights to reimbursement from children who default on their loans may not mean much. There is little point in taking costly legal action against children who do not have funds to repay their own debts.
If parents transfer property to children that has outstanding debt against it, the parents may continue to be legally responsible for that debt. If they sell indebted real estate to children, the lender retains the security interest in the property and the obligation of the original borrower. The parents' obligation can be released only by a voluntary agreement between them and the lender.
The purchaser's liability depends upon whether they purchase the property "subject to" the mortgage or the buyer "assumes" the mortgage. If the property is acquired "subject to" the mortgage, the buyer pays the seller the difference between the purchase price and the loan balance but does not assume a personal obligation to pay the debt. A buyer who "assumes" the mortgage pays the difference between the sale price and the loan balance and becomes personally liable for the debt. To detach themselves from further responsibility, the parents should require the buyer to assume the mortgage rather than selling it subject to the mortgage.