You May Want To Think Twice Before Cosigning a Loan

It’s hard enough to keep up with your daily expenses, loan payments, and credit card bills. But some people choose to take on extra financial liability and cosign a loan. Why would anyone do this? If you have good credit, you may choose to cosign to help someone close to you get approved for a loan or get a lower interest rate.

Having a cosigner can be helpful for the borrower, but cosigning also puts your personal finances at risk. This is especially true if the primary borrower makes late payments. This piece goes through the pitfalls of agreeing to cosign a loan and how you can best protect yourself from this potential harm.

What Is a Cosigner?

A cosigner, also known as a co-borrower, is someone who formally agrees that they will take on the loan if the initial borrower quits paying it back. So if the person who originally took out the loan defaults on it, the cosigner has to pay the creditor. They would be 100% responsible to repay the loan in this case. You can get a cosigner on many types of loans.

Cosigning a loan can lead to both positive and negative impacts on your credit report. This is true even when the borrower pays the loan back on time. Cosigning initially harms your credit score because the lender for the loan will do a hard inquiry. Hard inquiries always lower your credit score a little bit for a short period. 

Also, as a cosigner, you essentially take on more debt. This increases your debt-to-income ratio until the main borrower starts repaying the loan, which decreases this ratio. And if the primary borrower is late in paying back the loan or defaults on the loan, that will further harm your credit score as the co-borrower. That said, your credit score will improve if the borrower continues to pay back the loans on time.

Why Do People Cosign?

There are several reasons that people might cosign. Someone who has strong financial footing may cosign for a friend or family member who has bad credit because of financial hardship. A financial rough patch can hurt someone’s credit and disqualify them from getting some loans. Or they may have to put down a larger down payment or pay a higher interest rate, which makes the loan unaffordable. 

People also cosign because they want to help someone else to build credit. For example, parents commonly cosign for their adult children on student loans or mortgages for their child’s first home. Cosigning allows the adult children to benefit from their parents’ credit history and creditworthiness. 

Reasons To Think Twice Before Cosigning for a Loan

The Consumer Financial Protection Bureau (CFPB) requires lenders to provide a disclaimer to cosigners informing them about the risks of being a cosigner. Potential risks include:

• Damage to your credit score, which could impact your future ability to get loans or credit cards

• Debt collection activities, including being sued by the lender

• Negative impact on your personal financial situation

• Responsibility for paying the debt in full if the borrower doesn’t pay

Finally, if the borrower files bankruptcy, they will be cleared of their obligation to repay the loan, but you will still be responsible. That said, the borrower’s bankruptcy filing itself won’t hurt your credit score.

It's Difficult, but Not Impossible To Be Removed as a Cosigner

If you’re considering cosigning a loan for someone, it’s important to know that it’s difficult to be removed as a cosigner once the loan is in place. Prior to signing, you can try to establish a release clause in the loan terms that allows you to be discharged if the primary borrower makes a certain number of loan payments on time. Typically lenders will have to approve this kind of clause and many won’t. 

An easier solution is to ask the borrower to consider refinancing the loan once they have stronger credit. When they refinance, they essentially take out a new loan, and the goal here would be that you don’t have to cosign that new loan.

How To Protect Yourself if You're a Cosigner

If you agree to cosign a loan, you can protect yourself by keeping records of all of the messages between the borrower and the lender. You can request that the lender send you a copy of all correspondence. Also, make sure you can access the loan payment history online at all times, so you can see whether the loan is being paid on time. Finally, put aside some money, so that you’re ready if the borrower falls behind on their monthly payments and you become responsible for those missed payments.

Alternatives To Cosigning

If you want to help someone in your life who is struggling to get a loan or good loan terms without cosigning, you still have options. You can:

• Give them the money directly. Though this costs you more, it doesn’t put your credit at risk. This is particularly something to consider if you are trying to help your kid with expenses like an auto loan, student loan, or rent. 

• Provide collateral for the loan rather than cosign. Again this limits the loss you could face and won’t hurt your credit. 

• Give them a personal loan from your own funds, so the loan doesn’t risk your credit.

Let’s Summarize…

Many people decide to cosign loans for admirable reasons, such as to help a son or daughter with a student loan or help their friend to get a car loan. While cosigning comes with many benefits for the primary borrower, it comes with several risks for the cosigner and can impact their personal finances.

As a cosigner, your credit score will take a hit with the initial hard inquiry for the loan. Though this is likely to be small and will recover quickly, your credit is also at risk if the borrower misses payments or makes late payments. If you do choose to cosign a loan, you can limit your risks by keeping track of what’s happening with the loan payments. You may also be able to eventually get off the loan by encouraging the borrower to refinance. If you don’t want to cosign, you can help out in other ways that don't’ put your credit on the line, such as giving a personal loan.