When shopping for loans, one of the first pieces of information requested by lenders is the applicant’s financial history. This usually includes metrics such as Credit Score or Debt-to-Income ratio (DTI.) Generally, the better one’s financial indicators are, the better loan terms one can secure.
Those with either a poor credit history or no history often face high-interest loans or an inability to receive financing altogether. For those individuals, finding a “co-signer” or another individual to back their loan may be the best option if they need to borrow money. While undertaking this role and helping a loved one get the money they need is enticing, it carries some financial risk. This article will explore the pros and cons of co-signing a loved one’s loan and whether it may be right for you.
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What Does It Mean to Co-sign a Loan?
Co-signing a loan entails providing legal and financial backing to another individual as a form of security when that individual is applying to borrow money. A co-signer is usually a friend or family member with positive financial indicators that becomes legally responsible for making the loan payments if the borrower cannot do so.
Loan terms are personalized and dependent on the lender’s perception of risk on behalf of the applicant. Lenders perceive those with poor financial indicators, such as low credit scores or a high DTI, as having a higher risk of not paying back the borrowed sum.
When an individual co-signs a loan, they offer their financial profile as a supplement to the applicants’. Therefore, during the application process, the lender factors in the credit indicators of both the applicant and the co-signer. As a result, a co-signer with good credit can help the applicant access the loan they need and at better terms. This is possible because the co-signer has effectively agreed to take responsibility for the loan if the payments are not made.
Why Might Someone Need a Co-Signer?
For many people with bad credit or no credit at all, it can be very difficult to get a loan. Because lenders look to credit scores as a method to predict whether someone is a risky borrower, having no credit history or bad credit history may make it difficult to be approved.
If an individual in this situation is approved, they often will receive a loan with poor terms, also known as a subprime loan. Sub-prime loans often have high-interest rates, complicated rules, and steep penalties.
How Does Co-Signing Work?
Say your 19-year-old son or daughter just started a new job across town and needs a car to get to work. As they probably do not have much or any credit history, auto loan approval would be unlikely because most lenders would see them as high-risk. Adding your name alongside your child’s on an application decidedly raises their chances of being approved for a loan, perhaps even one with favorable interest rates.
While this can be invaluable in helping a young adult or struggling friend get their footing in the world, it is one-sided. Co-signing is much more than providing this lender with a character reference; you’re committing yourself to any debt incurred by the loan. If your loved one is incapable of paying back the loan on time or at all, it becomes your responsibility to do so for them.
Co-signing a loan or mortgage should not affect your taxes as long as your cosignee files theirs correctly. If you co-sign a mortgage for your child, they can claim all the deductions and deal with the property tax independently.
The co-signer is considered a guarantor and does not have to worry about filing paperwork if the debt is forgiven or written off. That said, you will not be eligible for any tax advantages associated with the loan, mortgage, or relative material equity.
Not only can co-signing a loan incur significant financial consequences, but it could also lead to personal issues. Imagine a friend or family member you thought you trusted missing payments they ensured they could handle, effectively leaving you with massive debt and tanking your credit. Most people would struggle not to feel at least some resentment toward the negligent party.
Pros of Co-signing a Loan
While co-signing a loan is often a one-sided arrangement, there are some long-term benefits possible from doing so. These include:
- Access to better loans: Generally, having a cosigner can reduce the interest rate by up to 1-2%, although the amount of interest reduction may also vary depending on the creditworthiness of both the borrower and cosigner.
- Improving the co-signer’s credit: Those who co-sign a successfully repaid loan may see their financial indicators and credit score improve over time. This could ultimately help the co-signer receive more significant sums of borrowed money in the future with more favorable terms.
- Improving the borrower’s credit: Co-signing a successfully repaid loan for a friend or family member with financial difficulties could help set them up for a lifetime in good financial standing by allowing them to establish good credit or improve their bad credit. This could allow them to avoid looking to the co-signer for financial assistance in the future.
- Helping a loved one in need: While it may not improve one’s financial profile, assisting a friend or family member in need comes with its own benefits.
Cons of Co-signing a Loan
Unfortunately, a co-signer is ultimately responsible for the repayment of the borrowed sum. This means co-signing comes with risks:
- Responsibility for payments: If the borrower neglects payments on the loan, you are still financially and legally responsible for making them. If you cannot afford to pay the loan, you are liable to become the subject of litigation if the lender decides to sue you.
- Reduced credit score: Because you are financially and legally responsible for the borrowed sum, the co-signed loan will be factored into your credit score. Therefore, your credit score will decreaseif you or the borrower do not make payments.
- Limited borrowing power: Creditors look at both your credit score and debt-to-income (DTI) ratio when considering you apply for financing. Even if your loved one pays their bill on time, the additional debt incurred in your name affects your DTI regardless making it harder for you to borrow money on your own behalf.
- No opt-outs: Once you co-sign a loan, it is not possible to back out. Because loans often take years to be repaid, you could be responsible for paying the loan and dealing with the financial consequences for a long time.
How Much Does Co-signing Affect Credit Score?
Co-signing a loan can significantly affect one’s credit score both positively and negatively. If the primary borrower makes consistent payments, it will improve your credit score. If they do not, it will quickly fall.
Here are a few of the ways in which co-signing a loan can affect one’s credit score.
The Loan Amount
From the outset, your credit score may decrease, at least in the short term. The first factor in how much your credit score could shrink pertains to the loan size. Considering that the amount you owe makes up 30% of your credit score, taking on more debt than creditors think you can handle can severely affect one’s financial standing. While this limit is up to the discrepancy of the creditor, make sure to consider what your DTI will be after taking on this added financial responsibility.
Hard Credit Pulls
Each time you apply for a line of credit, the borrower will perform a “hard pull” of your financials, decreasing your credit score by 3-10 points, which can add up if repeated many times. A hard pull entails ordering a thorough account of one’s finances, including more than one’s current score. It includes information on your income, other LOCs, payment history, and even what assets you own, such as stocks and bonds.
Should the loan be properly serviced from this point forward, there are no further risks to the co-signers financials. However, it may take several months for their credit score to recover following the inquiries.
Missed Payments After 30 Days
If one misses a payment on a loan, the effects can be swift and severe. If an individual is just 30 days late on a payment, the co-signers credit score could drop by as much as 100 points. That’s enough to re-classify one’s credit score from “very good” to “average.”
Missed Payments After Three Months
Suppose payments continue to be neglected after three months. In that case, the lender will sell the debt to a private collections agency, which then becomes responsible for receiving your money. The sale of your debt to a collections agency can further reduce your score by 100 points. From there, each month you pay, your credit score will decrease periodically, though to a lesser degree.
Remember that creditors keep their formulas for determining scores secret, so these are just estimates. Regardless, if you or the borrower neglect payments, the effect will not be good.
Protecting Yourself as a Co-signer
Before agreeing to cosign a loan, be aware that you may be held liable for any unpaid debt if the primary borrower defaults on their payments. This could lead to collection agencies contacting you and even legal action being taken against you in some cases
If you have thought all this through and still feel it right to co-sign a loan for someone dear to you, take these measures to protect yourself further:
- Thoroughly compare the various available lenders and offers.
- Get online statement alerts from the account.
- Have the lender keep you notified of overdue payments.
- Set aside money to bail yourself out, just in case your consignee drops their end of the bargain.
- Communicate upfront and regularly with the consignee about the importance of paying the loan, and remind them how direly this affects you.
Lastly, if you don’t completely trust your friend or loved one to pay back the loan responsibly, you should elect to not co-sign the loan. While this could be awkward and potentially upsetting at first, it could be the best move for your relationship over the long term.