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Cosigning a Loan – Understanding the Reasons & Risks

By Valencia Higuera

loan application cosignThere are no denying the benefits of having a high credit score. It allows you to be eligible for credit cards, auto loans, mortgage loans, and other types of loans with little hassle, providing you have adequate income. Good credit also justifies a low interest rate, which means lower monthly payments.

While loan officers fight for your business, they aren’t the only ones who take notice of your solid credit. If you’re the financially responsible one among your family or circle of friends, there’s a chance that someone will ask you to cosign a loan.

Cosigning is a common practice in the lending world, and it gives you an opportunity to help another person. But before eagerly agreeing to cosign a loan, seriously consider the risks and benefits to determine whether it’s a good idea.

What Is a Cosigner?

A cosigner is a person who agrees to pay a borrower’s debt if he or she defaults on the loan. The person asked to cosign a loan usually has a good credit score and a lengthy credit history, which greatly improves the primary borrower’s odds of approval.

Cosigners play a valuable role in the lending world, and without cosigners, many people would have difficulty getting first time credit. But despite the usefulness of this provision, cosigners tread in dangerous waters.

Reasons to Cosign a Loan

Cosigning isn’t always a terrible idea. In fact, there are a couple of sound reasons to cosign a loan:

1. It Helps an Applicant Obtain Financing
When purchasing a new vehicle or attending college, it’s normal for people to take out a loan. Take away the availability of loans, and options are limited.

Credit and loan rejections are a reality for people with poor credit history. But sometimes, creditors and lenders will reconsider an application if there’s a cosigner. Taking a chance and cosigning can give someone the opportunity to obtain reliable transportation, attend school, or move into a safe community.

2. It Helps an Applicant Build Credit
Obtaining credit is needed to build credit, but unfortunately, it’s challenging for people without a credit history to qualify for new accounts. As a cosigner on a loan, you have a hand in helping another person establish or build a better credit score and credit history.

cosign loan couple

Reasons Not to Cosign a Loan

Unfortunately, the risks of cosigning a loan greatly outweigh the benefits. Before agreeing to cosign, understand the possible dangers:

1. It Increases Your Debt-to-Income Ratio
Your debt-to-income ratio is the percentage of your debt payments in relation to your income. To calculate your debt-to-income ratio (DTI), divide your monthly debt payments by your monthly income. For example, someone who earns $6,000 a month and has debt payments of $4,500 has a debt-to-income ratio of 75%.

Unfortunately, many people fail to realize how cosigning impacts their own debt-to-income ratio. Being a cosigner isn’t a verbal agreement that lenders forget once a primary applicant acquires the loan. As a cosigner, you’re attached to the loan. You’re required to attend the loan closing and sign the loan documents.

The loan appears on your credit report, and the monthly loan payment factors into your debt-to-income ratio – regardless of whether the primary applicant makes the payment each month. Because you’re liable for this balance in the event of default, being a cosigner can decrease your ability to get new credit.

But this isn’t the only consequence of a higher debt-to-income ratio. Cosigning a loan can also lower your credit score because the amounts you owe makes up 30% of your FICO score. Thus, the more debt you have, the lower your credit score. Ideally, your debt-to-income ratio should be no higher than 36%, as your credit score will drop as your debt approaches or exceeds this percentage.

2. You Can’t Remove Yourself as Cosigner
Cosigning isn’t something that you consent to for only a few months. Once you accept this responsibility and sign the loan documents, you’re tied to the debt for as long as it’s owed. You can’t renege or beg the lender to take your name off the loan.

However, in some cases, the lender may include a cosigner release clause in the loan agreement, which removes you as cosigner once the primary applicant demonstrates a history of timeliness. These clauses are common with student loans, but you can take a chance and request this provision from any lender.

Otherwise, the only way to remove your name as cosigner is for the primary applicant to refinance the loan and re-qualify on his or her own.

3. You Could Ruin Your Credit
There’s nothing wrong with helping a loved one or friend, but emotions shouldn’t guide your decision. There is a reason why this person can’t qualify for a loan on his or her own. It’s understandable if he or she doesn’t have a prior credit history. However, if the person requesting a cosign has a history of defaulting on loans or paying bills late, proceed with caution. History may repeat itself, in which case, your score will suffer.

Remember, this loan appears on your credit report. Thus, any lateness or skipped payment is noted on your report. Seriously consider whether cosigning is worth the financial and credit risk.

When Does Cosigning Make Sense?

While there is no good financial reason to cosign a loan, cosigning is ultimately a personal decision. In some situations, it’s the means to a greater end, and your personal reasons for cosigning may outweigh the financial risks. For example, you might cosign a credit card application or apartment lease for your child to help him or her become financially independent quicker.

Cosigning can also make sense if you don’t plan on financing anything in the near future. Because this loan raises your debt-to-income ratio, you may have difficulty qualifying for a mortgage or auto loan of your own until the debt is paid.

However, for cosigning to make sense, honestly examine your financial situation to see if you can afford the payments in the event of default. If you can’t, don’t take the risk.

Final Word

Someone in need of a cosigner may beg and plead for your help. And if you respectfully refuse to lend a helping hand, they might try to make you feel guilty. However, ultimately, it’s your credit on the line. You’ve spent years building an excellent credit history, and it only takes a few skipped or missed payments to undo your hard work and reduce your ability to qualify for low rates – or even get financing.

Have you ever cosigned a loan?

Valencia Higuera
Valencia Higuera is a personal finance junkie who enjoys reading articles on budgeting, saving money, and credit cards. She has written personal finance articles and blogs for several online publications. She holds a B.A in English from Old Dominion University and currently lives in Chesapeake, Virginia.

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Comments

  • http://www.yourfinances101.com/blog David/yourfinances101

    This one could easily be called “The One Good Reason…” because the first one is all you need to know.

    You can get seriously messed up financially if you do this, and the person defaults.

    I’d even think twice before doing it for a spouse…you better make sure he/she really loves you before doing so, because they are just as able to default as anyone else.

  • http://www.pfsdebtrelief.com Stephan

    It all comes down to trust in my opinion. if you trust the person, you would obvisouly help the person out if they are in a financial problem ( not being able to make payments). While i have never cosigned before, i cant even imagine not signing for your spouse David. You would marry the person, have kdis with the person, but not cosign a car loan? Thats just ridiculous. A divroce will be a lot more costly than a car loan that went into default.

  • Karmella

    I think it usually doesn’t go anywhere good – but refusing is probably an art in itself. I can’t imagine having that conversation, I honestly am not sure how I would say that (if it isn’t clear, I’ve never been in that position – my dad cosigned my first car loan but that’s the extent of my experience).

  • Winston

    Well, it depends my relationship with and understanding of that person. If I am very close to that individual and I know he/she is responsible, then I wouldn’t mind co-signing. And if he/she has trouble keeping up with the loan, then I would gladly pay some months for that person as a loan.

  • Stephanie

    The only person I’ve ever co-signed for is my husband…and I’m the one that writes the checks, so if he defaults, it’s MY fault. My sister asked me to co-sign for her, and I refused because it’s just too risky and her reasoning was to pay off her credit card debt. It was just a bad idea all the way around (for her included!). We found a way for her to pay off the cards and not have to trade one debt for another though, so it did work out.

    • Judith

      So sorry. I know I asked how you were able to pay off the cards without trading one debt for another but can’t remember what your response was. Could you please tell me again? I”d be extremely grateful.

  • Sally Aquire

    Thanks for commenting, Stephanie! I definitely agree that it’s a risky proposition. Glad that you found an alternative option that suited everyone!

  • Long

    Have great credit. Co-signed for someone I completely trust, plus knew that if in the even that the individual I co-signed for couldn’t make a payement, I could make that payment. Never regretted it. Article should’ve avoided the word “never” in the title. In most cases, Sally is right, but not in all cases.

  • Mortgage Brokers

    I suggest do not co-signed if the loan is for personal purpose but in my part I agreed to co-signed a credit line of my friend.. I didn’t hesitate because I can see that it’s for business purposes so I will be a big part to his business and I am sure he can take care of his loan..

    • http://www.facebook.com/tjamison77 Todd Jamison

      So what happens if your buddy’s business doesn’t pan out? Then you’re going to be stuck with his credit line debt. Not smart…

  • http://www.facebook.com/tjamison77 Todd Jamison

    The reason that the bank is requiring a co-signer is they are worried that the loan won’t be paid back by the borrower… Dude, if the bank won’t write the loan, that should be a HUGE warning sign. Steer clear of cosigning. If anything, give the borrower some funds to help with the down payment, and the bank may finance the note without need of a cosigner…

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