Implications Of Co-Signing A Loan With Someone

The Pros and Cons of Co-signing Loans

You might want to help a loved one obtain a loan by co-signing. Learn more about the pros and cons of co-signing loans so you can be sure you know what you’re getting into as a co-signer.

When a friend or relative asks you to co-sign a loan, your first instinct may be to agree and help them out of a tight financial spot. That’s understandable: When done responsibly, co-signing can be an invaluable tool for helping a loved one with poor or limited credit history gain access to the housing or credit they need. However, before you pick up that pen and sign on the dotted line, be sure you know how attaching your name to someone else’s debt may potentially impact your own finances.

What does it mean to co-sign a loan?

Co-signing for someone means you’re taking responsibility for the loan, lease or similar contract if the original borrower is unable to pay as agreed. Whatever you co-sign will show up on your credit report as if the loan is yours, which, depending on your credit history, may impact your credit scores.

Co-signing a loan doesn’t necessarily mean your finances or relationship with the borrower will be negatively affected, but it’s not a decision you should make lightly. Before you agree to help out, sit down with the borrower to discuss the situation and the borrower’s plan to keep up with their financial obligations. Make sure you both understand what is required of you as the co-signer, and together weigh the pros and cons of this action on your relationship. Take special care to discuss what will happen should the borrower be unable to keep up with their payments as agreed and ensure they understand how you may be affected as well.

The benefits of co-signing a loan

Clearly, co-signing a loan is most beneficial for the individual for whom you agree to co-sign. It can be a great way, for example, to help your child build credit. When a young adult is just starting out, it can be hard to get a loan or credit card with a decent interest rate because they lack the credit history that lenders use to determine if a prospective borrower is reliable. Co-signing for your child allows them to start building the credit history they need while reassuring the lender that they’ll get repaid.

Possible disadvantages of co-signing a loan

By co-signing for another individual—child or otherwise—you are putting yourself on the line for that person’s loan. If the borrower is responsible in their repayment habits, there should be no negative impact on you, but if you find that is not the case, you could be seriously affected:

It could limit your borrowing power. Potential creditors decide whether or not to lend you money by looking at your existing debt-to-income ratio. Depending on how much debt you already have, the addition of the co-signed loan on your credit reports may make it look like you have more debt than you can handle. As a result, lenders may shy away from you as a borrower.
It could lower your credit scores. Because that debt shows up on your credit reports as if it were your own, your credit scores will be affected by any late or missed payments. If the borrower stops paying altogether and the loan goes into collection, that could also go on your credit reports, and the bill collectors could come after you to get their money. Lenders or collectors could even sue you, garnish your wages or put a lien on your property in an effort to collect the balance of the debt.
It could damage your relationship with the borrower. You should also consider how co-signing a loan might impact your relationship with the borrower. You’ll be tied to this person, and any possible financial upheavals, for the term of the loan, whether that’s six months or 10 years. You’ll be responsible for repayment if the borrower has financial difficulties or if something else goes wrong, and your relationship could suffer.

As with many aspects of personal finance, there’s nothing wrong with helping out a friend or family member in need. Just make sure that you’re ready for any impact on your own financial situation before you lend a hand to a loved one.

What Are Co-signers Liable and Responsible For?

If you’re fortunate enough to have good credit, there’s a good chance that someday a loved one will call asking for you to co-sign a new loan or a credit card. Maybe it’s an adult son or daughter without much of a borrowing history or one who’s taken a few hits in recent years and needs a co-signer to buy a car. If you’re like most people, your impulse is to lend a helping hand by adding your signature to the loan. But before signing on the dotted line, make sure you know what you’re getting into.

Co-signers can face significant repercussions if the primary borrower can’t make good on his or her payments. Were this not the case, having a co-signer on the loan—regardless of how high their credit score—wouldn’t matter much to the bank. But because the lender knows it can go after co-signers for overdue payments, that second signature can make a world of difference in the loan approval process.

KEY TAKEAWAYS

Borrowers may ask a family member or friend to co-sign a loan due to low credit scores, lack of credit history, or because their loan is offered with a very high interest rate.
A co-signer on a loan is legally responsible for the debt if the primary borrower defaults.
Co-signing a loan will show up on your credit report and can impact your credit score if the primary borrower pays late or defaults.
Co-signers may sign for student loans, personal loans, credit cards, and even mortgages.

The Potential Fallout

What’s the upshot for the co-signer if the primary borrower can’t make the loan payments on time? The creditor may start contacting you seeking the overdue amount, using the same tactics that they use on lapsed borrowers. That means they could sue you and, if they win, garnish your wages.

Of course, by the time a collection agency starts calling, there’s a good chance the overdue payments have already found their way onto your credit report. So despite the fact that you’re not even borrowing the money in any real sense, your credit could start to take a hit. All of a sudden, obtaining loans—or at least getting preferred interest rates—can become a big challenge.

The important thing to keep in mind is that, legally, co-signers are every bit as responsible for the debt as the person they’re helping out.

Keep in mind, too, that you could remain on the hook even if the person you’re helping out files for bankruptcy. If the note you co-signed was part of the court filing, the creditor can still come after you in hopes of collecting on it.

Even if you acted as a guarantor on the loan rather than a co-signer, you’re in pretty much the same boat. There are some slight differences between the two. For example, with a guarantor, the lender has to pursue the primary borrower before contacting you. But you’re ultimately responsible for any late payments, just as you would be if you had co-signed.

Before You Sign

To avoid any unnecessary headaches later on, it’s important to think through your decision before putting your name on someone else’s loan. Here are three tips that can help keep you out of trouble:

Understand the Consequences

If you’re a co-signer, the creditor has just as much right to collect from you as from the actual borrower.

Stay in the Loop

The only thing worse than having a collection agency breathing down your neck is not knowing ahead of time that the loan wasn’t being paid. Before co-signing a note, the Federal Trade Commission (FTC) recommends asking the creditor to notify you if the borrower falls behind on their debt.

For peace of mind, make sure to get this agreement in writing.

Be Careful About Collateral

If you put up assets to help someone secure a loan—whether it be your car or an expensive piece of jewelry—know that the bank can sell them to help pay off unpaid debts. Make sure you’re ready to handle that reality in a worst-case scenario.

The Bottom Line

It’s easy for those with good credit to follow their heart and instinctively co-sign for loved ones who need a loan. But to avoid trouble down the road, it’s always a good idea to take emotion out of the equation and think through the consequences.