If you’re the financially responsible one in your family, your family members may ask you to cosign their loan. It’s no secret that borrowers with great credit get better interest rates and terms, but it’s not right for everyone.
Here’s what to consider before cosigning a loan for someone.
What Does it Mean to Cosign a Loan?
A cosigner agrees to pay the debt if the borrower doesn’t. For example, if you cosign your son’s car payment and he loses his job and can’t pay, it’s your responsibility. You agreed to pay the loan if he couldn’t.
Now you’re on the hook for the payments your son can’t pay, plus your own bills. Is this something you want to take on?
This doesn’t mean you should never cosign a loan for someone, but only certain people should. Before deciding, you should know the reasons and risks involved.
What are the Reasons to Cosign a Loan?
There are a million reasons you could cosign a loan, but here are the most common reasons:
- Help your child pay for (and afford) college
- Help a family member buy a car for reliable transportation
- Help a family member buy a house and invest in a home rather than renting
- Cosign a lease to help your child get their first apartment
- Cosign a credit card to help a family member build credit
When is Cosigning a Loan a Good Idea?
Cosigning a loan requires careful consideration. There isn’t a standard set of requirements you should meet to decide cosigning is a good idea.
Look at the situation. What are the odds that the personal you’re helping will make the payments and continue to be able to moving forward?
If it’s a child you’re helping, are you willing and able to take care of the payments if he/she can’t? It’s not a question of whether you want to – you’re obligated to do so if they don’t pay it. If you (or they) don’t, you’ll ruin your credit along with theirs, defeating the purpose of cosigning a loan.
Why and When is Cosigning a Loan a Bad Idea?
A majority of the time, cosigning a loan is a bad idea. If like I said above, you know there’s a chance the borrower won’t pay the loan, you’re on the hook.
If you can afford it, great. If you can’t, though, you’re in trouble. Look at your debt-to-income ratio (your total debts compared to your income). Can you squeeze in another debt if you must? It’s not ideal, but paying it is better than ruining your credit too.
If you’re unsure of the borrower’s ability to pay, it’s a bad idea or if you aren’t close enough to ask questions about his/her ability don’t do it. It seems like the ‘right’ or ‘nice’ thing to do, but it’s not. If the borrower can’t afford the loan, it doesn’t make sense to put him or you in that position.
What are the Risks of Cosigning a Loan?
Most people don’t realize the risks of cosigning a loan. You’re doing more than putting your name on a loan. You risk a lot including:
- You could be on the hook for the entire loan amount. Whether you pick up the monthly payments or you have to make good on the past due amounts, it’s not good for your pocketbook or your credit score.
- You could damage your credit score. Payment history makes up a majority of your credit score (35%). If the borrower doesn’t pay (and you don’t either), you get hit with a late payment. Even one 30-day late payment may knock your credit score down significantly. If it gets to 60-days or more late, the damage to your score will be devastating.
- If you ruin your own credit, you’ll have trouble getting loans moving forward. Even though you were the cosigner, you’re still affected. Lenders can’t tell if you were the borrower or cosigner looking at your credit report and they won’t care. A defaulted account is bad no matter which way you slice it.
- You are stuck on the loan. Removing yourself as cosigner is only possible when the borrower qualifies for the loan on his own. The borrower has to refinance and qualify for it.
- It could ruin your relationship. Money and relationships are tricky business. Asking your loved one to make their payment is tricky. If he/she can’t, then what? Is there friction between the two of you? Does it affect your relationship?
Protecting Yourself if you Cosign a Loan
If you cosign on a loan, know how to protect yourself first.
- Work out an agreement with the borrower. Do you want access to the loan dashboard? How will you know if the borrower isn’t making payments?
- Talk to the creditor. Do they send cosigners notices and statements too? If not, find out how you’ll know if the borrower isn’t making payments.
- Put everything in writing. Don’t agree to anything verbally. Put everything in writing then there’s no room for disagreements or hard feelings (although they still happen.)
Typically, I’d advise against cosigning on a loan. In rare circumstances when you know the borrower can make the payments and/or you can make them without stressing your finances, it may be okay.
Look at your other options though. Can you help your loved one in another way? Maybe a family loan, where you loan money you can spare and charge him/her interest? If your loved one is buying a house, can you help with the down payment rather than putting your financial reputation on the line?