Cosigning a Loan
Having a high credit score qualifies you for more than just great interest rates. It is critical when it comes to cosigning a loan.
As a responsible borrower, it takes years to build a solid credit history, which includes responsible repayment of debts and management of your debt-to-credit ratio among other things. However, with a strong, reliable income and organized repayment habits building a credit score is relatively easy over time.
Unfortunately, destroying that credit score through a few missed or late payments is even easier – and takes far less time. Thus, millions of Americans struggle not only with debt and general financial management, but also access to the credit they need to get on their feet. As someone on the opposite side of that fence, it may be tempting to help out by cosigning on a bank loan or credit card. Yet, while signing on the dotted line to help out a family member or friend is a simple act, it can have major repercussions that affect your own credit and financial future. So while ultimately cosigning a loan is a personal choice, it is important to be aware of the incredible risks you take by doing so.
What Does Cosigning a Loan Really Mean?
There are five major ways that you can be associated with a credit account (be it a credit card or loan). They are:
- Individual – the sole person responsible for the account
- Joint Contractual Liability – you are responsible for the debts on a joint account, often with a spouse or parent
- Authorized User – you can use the credit, but are not responsible for paying the debt
- Co-maker or Guarantor – also known as a cosigner. You guarantee the account and agree to assume responsibility for it if the maker should default.
- Maker – you are responsible for an account which is guaranteed by a cosigner.
Basically, a cosigner on a loan is someone who lends his or her name and good credit score to that loan, which is issued to a separate party or maker. Ideally, as the cosigner, your obligation ends there. However, legally speaking, as a co-signer you are just as liable for the loan repayment, as well as any fees and interest it accrues, as the primary maker. This means that, should he or she default on that loan, you are not only liable for the repayment, the lending of your name and credit score means that the ultimate negative impact will affect you, too.
Why Cosigning a Loan Can Be Good
There are two, major arguments in favor of cosigning a loan, both of which are highly emotional. First, cosigning a loan allows the primary borrower access to cash for critical needs such as transportation (i.e. a car loan), education, or housing. Cosigning a loan in this case can be the first step in helping someone become financially stable through work or education. It can also mean helping someone you love get into a better situation or lifestyle.
Second, cosigning a loan helps the primary borrower to build their credit for the future. This is the justification used by many parents who cosign loans for their young adult children who may have adequate income, but lack the credit history needed for major purchases such as a vehicle. By receiving the funds from a cosigned loan and then responsibly paying the loan back, the young and inexperienced borrower builds meaningful credit with your help.
Why Cosigning a Loan Can Be Bad
Unfortunately, in most cases the negative effects of cosigning a loan outweigh the positive ones. In fact, according to the Federal Trade Commission (FTC) three out of every four cosigned loans in America are repaid, at least in part, by their cosigners when borrowers fail to make timely payments. This is because, legally speaking, a cosigner is just as obligated to pay as the primary borrower. Here are some of the scariest risks associated with cosigning a loan:
- You impact your credit score.
As the cosigner on a loan, your credit score is impacted in the same manner as if you were the primary borrower. The loan impacts your debt-to-income ratio as well as your credit utilization ratio. This means that, should you apply for a loan yourself, the presence of this loan can affect what lenders offer in terms of both principle amounts and interest rates. Furthermore, any late payments or defaults will appear on your credit report as if you had committed the offenses yourself, potentially ruining that good credit score you worked so hard to build.
- You cannot get off the loan.
Cosigning a loan is not a temporary thing – it is for the life of that loan. In fact, the only way to get out of your obligation on a cosigned loan is to either pay it off or have the primary borrower apply for refinancing – something that may be quite hard to do if they still lack the credit to support it.
- You may have to pay – A LOT.
Should the maker of the loan default, miss payments, and/or rack up fees (including legal fees on the part of the lender), you are as obligated as he or she is for their repayment. Furthermore, many lenders will skip right over the primary borrower on a cosigned loan, since they usually don’t have the means for repayment, and sue the cosigner instead. This can lead to a mountain of legal headaches, not to mention even more expense.
Should You Cosign a Loan?
There are ways to help out a loved one financially other than cosigning a loan. For example, if your goal is to help someone you love get cash, it is far less risky to do so through a personal loan if you can. In this case, even though you still risk nonpayment, their default will not affect your credit score or increase the principle. In a case when you want to help someone build credit, helping them finance a secured credit card is just as effective. For as little as $500, a secured credit card allows borrowers to exercise responsible credit repayment and build their score rapidly without the additional legal obligation of a loan.
Ultimately, when it comes down to it, choosing to cosign a loan is incredibly personal. It is something that can be done successfully, but only when the cosigner takes the time to really assess the risks and benefits.
**Have you ever cosigned a loan? How did it work out? What advice can you offer to others thinking about it?**