Have you ever been asked to co-sign a loan? Maybe a friend, relative, or family member is having trouble getting a loan and they need someone else to co-sign. Or maybe you are a parent with a teenager who is trying to get a credit card and can’t because of the new credit card rules for teens. What should you do? You are naturally a nice person and would like to help them out, but is it worth it?
These questions play out every day for thousands of people. It’s even more common these days now that credit has been significantly tightened. Unless you have a relatively high credit score you simply may not be able to borrow money that you could have just a few years ago. One of the only ways to get around being denied outright is to have someone with better credit or more income to sign the loan or line of credit with you. While this may help you get the loan, the co-signer is taking on quite a bit of risk as well.
What Are the Chances the Borrower Will Default?
According to the FTC, studies have shown that out of all co-signed loans that end up going into default, three out of four of those end up having to be paid by the co-signer. This shows you that the odds are not in your favor if the borrower you’re helping does end up going into default.
Remember, your friend or relative has asked you to co-sign because they have been turned down for credit by a lender. Sometimes this is due more to a lack of credit history than bad credit, but the reality is that a lender, who is in the business of lending money, felt that the borrower is too much of a risk. If a company that’s in the business of lending money thinks the borrower is too much of a risk you should really consider that before you sign on the dotted line.
What Will Happen If the Borrower I Co-signed for Misses a Payment?
In most cases, if the borrower misses a payment, the lender can come after you first, without trying to collect from the borrower. The lenders know that as a co-signer you probably have more money and a means to make payments. They will try to collect the money themselves, but if things get really bad you could find that:
- You could be required to pay late fees.
- You could have your wages garnished.
- You could lose any property you pledged against the loan.
These are the worst case scenarios and they will obviously try to collect the payments directly and through collections first, but if neither you or the borrower can make the payments you will be on the hook and it could lead to big problems.
What Should I Consider Before Co-signing a Loan?
Before you co-sign for a loan, be sure you can afford to pay the debt if the borrower defaults on the loan. You may feel confident that this won’t happen to you, but consider the unexpected. Life happens. People lose jobs, get sick, and can otherwise be irresponsible. Just remember that even if the borrower falls on hard times you are on the hook for that loan.
When you co-sign a loan, be sure you are capable of repaying the loan, and that it wouldn’t cause a financial hardship or jeopardize your own credit. We all want to help our friends and family, but you also need to think about your own needs.
Will the Co-signed Loan Affect My Credit Score?
Yes. The loan you co-sign will show up on your credit report, which may prevent you from obtaining credit yourself. If you’re planning to buy a house, car, or other large purchase during the life of the co-signed loan, you may want to think twice. Even if you’ve never had to put a single dollar towards the co-signed loans, lenders see this loan like any other and treat it accordingly. It can affect your credit score, credit to debt ratio, and otherwise keep you from getting a new loan yourself or subject you to higher interest rates.
Is It Ever a Good Idea to Co-sign a Loan?
Despite the risks, there are times when it makes sense to co-sign a loan. For instance, many parents do it for their kids to help them establish credit. This is especially true with new credit card laws limiting credit to teens. It’s important to establish a credit history at a young age so as a parent you can get your kids off on the right foot by co-signing for them.
If you do help them out by co-signing a loan you should make sure you start with a low limit and set firm rules on how they can use the money. If you’re careful and set firm rules you can help your children build important credit history without subjecting yourself to very much risk.
And if you’re helping a friend in need and they only need a small amount of money, consider doing a personal loan first. It could be enough to keep them out of trouble, keep your credit history clean, and possibly prevent them from resorting to a costly payday loan.
Is There Anything I Can Do to Protect Myself If I Do Co-sign a Loan?
If you do decide to co-sign a loan, try to get the lender to agree in writing that in the event of a default, you would be responsible for only the principal balance of the loan. This would protect you against legal fees if the lender decided to sue. They may not always agree, but everything is negotiable and it’s worth a shot.
Also ask the lender to agree in writing to notify you if the borrower is late with a payment or request duplicate statements sent to your home. This could give you valuable time to try to rectify the situation before it gets out of hand. One of the worst things to happen is when the borrower is getting late on their payments but fail to tell you. Before you know it, they have dug themselves a deep hole and you don’t find out until it’s too late. If you can spot a problem early you may be able to avoid a potential nightmare.
Before you make the decision to co-sign a loan, you should know the purpose of the loan, type of loan, and terms of the loan. Think of yourself as a lender. Ask the borrower why they need the money. Is it to buy a home or a car? Are they trying to consolidate credit card debt? Trying to pay for school? Some loans are better than others, so you can be the judge as to what you want to help out with.
The Bottom Line
Think of co-signing a loan as taking the loan out yourself. For all intents and purposes, credit agencies and lenders will see it that way, so you should too. You may never need to pay anything towards the loan, but it can affect your ability to borrow money in the future so it is not a decision to take lightly. There are a few situations where it may make sense, but be sure you take all the necessary precautions and always plan for the worst so you don’t put your finances in jeopardy.
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About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.