When Should You Cosign On A Loan?
Each person has their own rules and philosophies about lending money to loved ones. For some, it's a minefield destined for avoidance at all costs. For others, money lent to friends or family members is essentially a gift, with repayment not expected but nice if they can manage it.
What if someone you know is asking you to lend your credit instead of your money? In general, the same principles apply. The risks, however, can often be much bigger.
If you're considering co-signing a loan for someone in your life, here are some things you'll need to understand before you agree and sign on the dotted line.
What It Means To Be A Co-signer
When you co-sign a loan, you become legally responsible for the repayment of that loan. As co-signer, you also agree to repay the loan if the primary borrower doesn't.
Getting approved for credit can be difficult for those who don't already have an established credit history or have bad credit. Having a person with good credit co-sign the loan can help these borrowers get approved, even if they don't meet the creditor's requirements on their own.
This is fairly common with private student loan borrowers. If the student borrower is a young adult with no previous credit history to prove their ability to repay a loan, they may need a co-signer, often a parent, grandparent or other guardian, to get approved for the loan.
While acting as a co-signer can help those who are in need of credit but can't get it, it also comes with a lot of risks for the co-signer, and very little reward.
How Co-signing Works
When you co-sign a loan, you aren't just helping to get the primary borrower's loan application approved, you're also on the hook for the entire duration of the loan. That loan is legally yours just as much as it is the primary borrower's.
This means that co-signed loans, and all the activity associated with them, including payment history, will show up on your credit report. If the borrower misses loan payments, the lender will turn to you to make them. If you don't, your credit score will take a hit.
You'll typically be responsible for a co-signed loan until it's paid off. In some cases, you may be able to apply for a co-signer release, which will allow you to remove your name from the loan if the primary borrower meets certain requirements, such as having made a specific number of on-time payments and meeting the lender's credit standards.
Co-signer releases are common with private student loans, but you may have this option on other types of loans. Talk to the lender or read your loan documents to find out if you have this option before signing any loan agreements.
Another way to get your name off a loan before it's paid off is if the borrower refinances into a new loan in their name only. This requires the borrower to have the credit and income to be able to qualify for a loan on their own.
Types Of Loans You Can Co-sign
Let's take a look at some of the things you'll need to consider with each type of loan you can co-sign.
Personal loans are flexible in that they're personal. You can use a personal loan for a variety of large purchases, however, not all lenders allow co-signers. A borrower may use a personal loan for home improvement projects or repairs, debt consolidation or unexpected costs that they can't cover out-of-pocket.
If you're asked to co-sign a personal loan, you might first want to inquire about what the person intends to use it for. If your loved one needs the loan to afford a vital repair to their home or to pay off medical debt, you may be more inclined to help them out than if they planned to use the funds for, say, a kitchen remodel.
However, no matter their reason for borrowing the money, your responsibility on the loan is still the same. Make sure you aren't jeopardizing your own finances to help them out.
Like personal loans, you should know that not all credit card issuers allow co-signers. If you're interested in helping someone build credit through a credit card, you might consider adding them as an authorized user on your account instead.
Whether you're considering co-signing a credit card or adding someone as an authorized user, make sure you understand the terms of the card agreement, including the interest rate and the credit limit, as this will give you some insight into how much you could end up paying if the primary borrower defaults.
For the most part, federal student loans don't require co-signers. Private student loans, on the other hand, might require a co-signer if the student doesn't have sufficient credit to be approved for the loan.
Co-signing a student loan for your child or another important student in your life can be a wonderful and generous gift to someone who is just starting out in life or embarking on a new journey.
Keep in mind, though, that students can sometimes struggle to find steady work in the first few months or even years after graduation. Before co-signing, you should think about whether you're financially prepared to step in and cover their payments if they aren't able to afford them. Otherwise, your credit could suffer, too.
Auto loans are a type of secured debt, meaning that the car acts as collateral for the loan. However, that doesn't mean that co-signing a car loan is any less risky.
Remember that when you co-sign on a car loan, you'll have no claim to the car that the loan is being used to purchase (unless your name is included on the vehicle's title, meaning you are the legal owner of the car).
It may be helpful to talk with the owner of the car about what type of car insurance they carry. For example, if the car gets totaled in an accident and the insurance pays out less than what is still owed on the loan, do they have gap insurance that will cover the difference? If they don't, you'll both be on the hook for the rest of the loan on a car that can no longer be driven.
Additionally, make sure you're informed on what your rights are in the event that the car gets repossessed. If this happens, the lender will typically try to sell the car at auction. If the car sells for less than what the remaining balance on the loan is, the lender can sue the co-signer for the balance if the primary borrower is unable to pay. The repossession will affect both the borrower's and the co-signer's credit.
Mortgages are another type of secured loan, with the home acting as collateral. Co-signing a mortgage can be particularly risky, as these loans are typically for large amounts.
Because these loans are such a big deal, the approval process for a mortgage is typically more stringent than it is with other types of credit. This means that certain people, such as self-employed individuals or those with a short credit history, can have a difficult time getting approved or gaining access to the best interest rates. In these situations, it might make sense for an applicant to ask a close friend or relative to co-sign their loan.
However, taking on responsibility for a home loan on a house that you don't own is very risky. If the primary borrower defaults and you aren't able to bring the account current, the lender will likely foreclose on the home.
Foreclosure is a major, negative credit event that can dramatically lower your credit score and prevent you from getting any type of credit in the near future. A foreclosure will remain on your credit report for seven years. You likely won't be able to find a lender who will approve you for a mortgage until the seven years has passed.
Things To Consider Before You Co-sign
The biggest thing to remember if you're considering co-signing a loan is that you should be fully prepared to make every single payment on the loan until it's completely paid off. If your finances can't handle that or you simply don't want to take on that responsibility, you shouldn't co-sign the loan.
Even if the person you're co-signing for has a steady job and sufficient income and truly plans on paying off the loan and making sure you never have to worry about it, things happen, and they could end up being unable to pay through no fault of their own.
The loan is legally yours, too, and you should treat it as such when deciding whether you can afford to take it on.
Keeping that in mind, here are some additional things you should think about if you're deciding whether to sign or not.
Know Your Rights
It's important that you understand what your rights are as a co-signer on a loan. Federal law requires lenders to provide you with a co-signer's notice listing what your obligations are as the co-signer. Here's what that notice will say, according to the Federal Trade Commission:
- You're 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, including suing you or garnishing your wages. 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.
Your state may provide more extensive protections for co-signers. For example, state law may require lenders first attempt to collect payments from the primary borrower before collecting from the co-signer. Or, your state may mandate that lenders inform co-signers when a loan has become delinquent.
Make sure you know what your state's laws are and what kind of protection you can (and can't) expect.
Understand The Contract
You may be able to have certain protections included in your contract, as well. Take the time to read all the relevant loan documents and make sure you know what you're agreeing to.
Pay attention to whether or not the lender will notify you of late payments. If this isn't included in the contract, ask it to be included in writing. That way, you won't be in the dark if things start to go south on the loan.
According to the FTC, you may be able to negotiate some of your liability with the lender. For example, you may ask if it's possible for you to only be liable for the principal balance. That way you'll only be responsible for the loan itself, and not any late fees or legal costs the borrower may incur.
Finally, get your own copies of all the important loan documents.
Consider Your Debt-To-Income Ratio (DTI)
One oft-overlooked aspect of co-signing a loan is how it can affect your own finances even if everything goes according to plan.
Remember that when you co-sign a loan, creditors view that loan as belonging to you. This impacts your DTI, or the portion of your income that’s spent on debt payments.
If the co-signed loan pushes your DTI too high, you may have difficulty getting approved for your own loan, even if the primary borrower has made every single loan payment on time.
If you're considering getting a mortgage in the near future, you'll want to keep your DTI below 50%. If co-signing a loan pushes your DTI past this point, you may want to reconsider.
If you're going to co-sign a loan for someone, you'll need to have an open and frank conversation about their finances, your own finances and if they're able to handle the loan payments.
It can be awkward but having a better idea of what their financial situation looks like can help you keep tabs and better evaluate your risk. Do they have a savings account for emergencies that could cover their monthly payments if they had to, or will they expect you to back them up if they have a budget emergency?
You should also consider asking the borrower for access to the loan account, including getting log-in credentials if the loan information is available online. That way you can check in each month to make sure the loan is still current and payments are still being made in full and on time.
Risks Of Co-signing A Loan
As we've already highlighted throughout this article, co-signing a loan comes with a lot of risks and very few rewards.
You may not mind having to cover the occasional payment for the person you co-signed for, but what if they were to completely stop making payments for the duration of the loan? Can you afford to pay off the entire loan with your own funds? If you can't, you'll likely take a significant hit to your credit.
Not only that, but any legal steps a creditor can take against a primary borrower, they can also take against the co-signer. This could include wage garnishment or seizing money from your bank accounts.
Another risk to consider is that you have more to lose credit-wise. You likely were asked to co-sign because of your great credit history. However, those with higher scores tend to be impacted more by negative marks such as late payments than those who have lower scores.
Of course, there's also the possibility that this situation could sour your relationship with the primary borrower. Even if all goes well, having to check in each month to make sure the borrower is still making their payments can put a strain on your relationship.
While co-signing a loan can be a generous way to help a loved one build credit, there are a lot of risks involved.
Life is unpredictable, and even those who have the best of intentions could end up in a situation where they simply cannot pay. If you co-signed the loan, the responsibility will then fall to you. Be sure you're ready for that, and that you aren't just co-signing because you feel it's the polite thing to do.
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