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Cosigning a Loan – Understanding the Reasons & Risks

Having a high credit score makes a greater difference in your life than you might think.

It allows you to take out mortgage loans, auto loans, credit cards, small-business loans, and other types of loans with little hassle, opening far more doors to you. Good credit also qualifies you for a much lower interest rate, which means lower monthly payments — sometimes hundreds of dollars lower.

Although loan officers compete 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 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 your friend or family member by opening those same doors to them.

But before casually agreeing to cosign a loan, seriously consider the risks and benefits. It’s no small favor, and you may be surprised when you learn what’s at stake for you.

What Is a Cosigner?

A cosigner is a person who agrees to pay a borrower’s debt if they default on the loan. The person asked to cosign a loan usually has a good credit score, lengthy credit history, and strong income, all of which greatly improve the primary borrower’s odds of approval.

Cosigners play a valuable role in the lending world; without cosigners, many people would have difficulty building their initial credit history. But despite the usefulness of this provision, cosigners tread in dangerous waters.

As a cosigner, you put yourself on the line as a borrower alongside the primary borrower. You take full legal and financial responsibility for the debt.


Reasons to Cosign a Loan

Although cosigners take a great risk, millions of people agree to cosign loans and leases every year. Why do they do it? Quite simply, to help someone they love.

Cosigning a loan for your friend or family member helps them in two ways and can create opportunities for them that they otherwise couldn’t access.

1. You Help an Applicant Obtain Financing

When enrolling in higher education or buying a starter home or car, it’s common for people to take out a loan. Take away the availability of loans, and their options shrink dramatically.

The same goes for applying to rent a first apartment. Many landlords are wary of applicants with no established credit history.

Credit and loan rejections are simply a reality for people with poor or no credit history. But sometimes lenders and landlords consider applications they’d otherwise decline if the borrower brings a cosigner.

Taking a chance and cosigning for a close friend or family member can give them the opportunity to obtain reliable transportation, attend school, or move into a safer community. As someone with good credit and income, you’re in a unique position to help your loved ones get off the ground.

2. It Helps an Applicant Build Credit

It takes credit to build credit. This raises a fundamental question: How do you get your first credit accounts with no established credit history?

The reality is that people without a credit history have a hard time qualifying 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.

After the first account or two, your friend or family member should have sufficient history to start qualifying for credit on their own — if they pay their bills on time, that is.

Pro tip: If you’re looking for other ways to build your credit, consider signing up for Experian Boost. Once you sign up for a free account, you can get an instant boost in your credit score.


Reasons Not to Cosign a Loan

The benefit to you as the cosigner is intangible: You feel good about helping someone you care about.

Unfortunately, the risks of cosigning a loan are extremely tangible. Before agreeing to cosign, you need to understand the dangers and exactly what you’re getting yourself into.

1. You’re 100% Liable

When you cosign a loan or lease, you take on 100% liability for it. Not partial responsibility, not half, but the entire thing.

Imagine you cosign a $150,000 mortgage for your son to help him buy his first home. He stops paying the mortgage, and the lender files to foreclose.

You’re legally liable for making those monthly payments, just as much as he is. You now have a choice. You can either make the monthly payments for him — potentially for the next 30 years — or you can let the loan go to foreclosure.

If it goes to foreclosure auction and sells for less than you and your son owe, you’re on the hook for the difference. Keep in mind that the balance will include thousands of dollars in back payments, late fees, attorney fees, and marketing fees for the auction.

The lender can sue you personally for the outstanding deficiency judgment. And this says nothing of the damage to your credit.

2. You Could Ruin Your Credit

There is a reason why your friend or family member can’t qualify for a loan on their own.

Granted, that reason may be that they haven’t established any prior credit history. But 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 credit will suffer a similar fate.

Remember, this loan appears on your credit report. Any late or skipped payments are noted on your report. Seriously consider whether cosigning is worth the financial and credit risk.

Keep in mind that your credit has further to fall than your friend or family member’s. They already have a bad credit score, so they have less to lose by making late payments than you do.

3. Your Monthly Budget Is Also on the Line

If the primary borrower fails to make payments, you’re on the hook for them. Are you really prepared to pay your son’s $1,200 mortgage payment or rent every month indefinitely?

Make no mistake: Your monthly budget is at risk. By cosigning, you’re agreeing to make those monthly payments just as much as your beneficiary is. That means you need to actually budget for the monthly payments, to add them as a line item in your monthly expenses.

Hopefully, your friend or family member makes their payments on time. But “hopefully” isn’t good enough when you’re talking about a legal obligation to pay hundreds or thousands of dollars each month.

Having to step in and start making payments can ruin your retirement planning or other major financial goals. Think long and hard about where the monthly payment would come from if you had to make it and what you’d be sacrificing.

4. It Increases Your Debt-to-Income Ratio

Your debt-to-income ratio (DTI) is the percentage of your debt payments in relation to your income. To calculate your DTI, divide your monthly debt payments by your monthly income.

For example, someone who earns $6,000 per month and has debt payments of $1,500 has a debt-to-income ratio of 25%.

Unfortunately, many people fail to realize how cosigning impacts their own DTI. 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 DTI — 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 DTI. Cosigning a loan can also lower your credit score because the total amount 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%, and your credit score will drop as your debt approaches or exceeds this percentage.

The bottom line: By cosigning for someone else, you jeopardize your own ability to borrow money in the future, whether to buy a new house, buy a car, or invest in your small business.

5. You Can’t Remove Yourself as Cosigner

Cosigning isn’t something 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 — which in some cases could be as long as 30 years. You can’t renege or beg the lender to take your name off the loan.

In some cases, however, 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 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 requalify on their own.

6. You Have to Track Payments

When you take on the responsibility of cosigning a loan, you add one more bill to keep track of every month.

You need to know if the primary borrower makes their payment or not, every single month, for the rest of the loan term. That means the added hassle of having to check up on the loan payments each month. It’s one more headache you probably don’t need in your life.

7. The Risk to Your Relationships

When you say no to a request to cosign a loan, you create friction once and for a short period of time. Your friend or family member will be disappointed, but hopefully, they’ll understand.

But when you agree to cosign a loan, you set the stage for constant conflict and friction. What do you think you’ll do when you check up on the monthly payment and discover your loved one hasn’t paid it yet, but it’s due today?

You’ll call them and demand they pay it, of course. They’ll view it as nagging, as you seethe over having to remind them to pay their own bills.

As the months go by, and you nag and they perhaps make a few payments late, the trust between the two of you erodes bit by bit. You stop trusting them to make their payments on time, and they know it.

All of this creates a recipe for resentment, anger, distrust, and disintegrating personal relationships. And if the primary borrower defaults on the loan completely, your relationship may be not salvageable at all.

8. Your Only Legal Recourse Is a Lawsuit

Imagine the worst happens, and your friend or family member defaults on the loan.

You can step in and start making the monthly payments to bail them out. You did sign a legal obligation to do so, after all, just like they did. Otherwise, the loan goes into collections or foreclosure, and the lender sues you personally for the money. Your credit takes an enormous hit in the process.

Either way, you suffer significant financial losses. And under the law, you only have one course of action: suing the primary borrower for your losses.

Of course, winning the lawsuit is only half the battle. Even if you win a judgment against them, you then have to collect it. That’s no easy feat. It usually involves paycheck garnishments, liens, and other expensive debt-collection tactics.

Do you really want to put yourself in a position where you have to pay your friend or family member’s debts, and the only way to recover your money is to sue them?

9. Potential Tax Consequences

Say the borrower defaults, and you call up the lender to negotiate the debt. Of the $20,000 auto loan, the lender agrees to accept $12,000.

You pay them $12,000 — a financial blow in itself. Then you get hit again by Uncle Sam, who requires you to pay income taxes on the $8,000 of forgiven debt. It’s called “debt forgiveness income,” and it’s treated just like any other income.

Plus, your credit still takes a hit. The debt would appear as “settled” rather than “paid as agreed,” and it would hurt your credit score.


When Does Cosigning Make Sense?

Although there’s no good financial reason to cosign a loan, cosigning is ultimately a personal decision.

In some situations, it’s a means to a greater end, and your personal reasons for cosigning may outweigh the financial risks for you. For example, you might cosign a credit card application or apartment lease for your child to help them become independent faster.

If your child needs a cosigner to take out student loans and needs student loans to attend college, then the benefit of helping them get an education may outweigh the financial risks to you.

Alternatively, you may face a choice between cosigning for an adult child or letting them move in with you. Suddenly cosigning might look a lot more appealing.

Cosigning is less risky if you don’t plan on financing anything for yourself 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. That matters less if you don’t expect to finance any large purchases any time soon.

In any case, 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.


If You Cosign: How to Protect Yourself

If you’re willing to take the risk to cosign for your friend or family member, you do have a few options to help protect yourself.

None offer ironclad protection, but take these steps to maximize your odds of surviving the cosigned loan with your budget and credit intact.

Get Online Access to the Accounts

You need your own login to access the loan account online. With a few clicks, you can check on the loan’s payment history and make sure the borrower has been fulfilling their debt obligations.

It’s part of the hassle inherent in checking up on the borrower, but it’s easier than having to call up the lender each month. Just remember that if you log in and find the borrower hasn’t paid as agreed, you’re now forced into the position of nagging them.

Ensure You’re Copied on All Correspondence

Whether the lender sends statements and notices by email or snail mail, make sure you receive them too.

If the primary borrower doesn’t pay, you need to know about it. Before agreeing to cosign the loan, talk to the lender directly to ensure they can copy you on all correspondence.

Beef Up Your Emergency Fund

As outlined above, you need to budget for the loan payments. You signed a legal obligation to pay them.

For the first 6 to 12 months of the loan, make the loan payments each month — to your emergency fund. It helps make the obligation real to you and ensures you can actually afford to make the monthly payments.

Just as importantly, it means you have plenty of money within easy reach to help cover the debt if the worst happens and your friend or family member defaults.

Plan an Exit Strategy With a Firm Deadline

You don’t want to sign a 30-year loan commitment.

Instead, form a clear exit strategy with your friend or family member. Plan out exactly when and how the loan will be repaid in full, so you’re not left with their debt obligation for years or even decades to come.

For example, if cosigning a mortgage, insist that the borrower take out a balloon mortgage that ends in three or five years, rather than a 30-year fixed mortgage. The borrower can then either refinance or sell the property, thus relieving you of your obligation.

Alternatively, if you’re cosigning a lease agreement, insist that the landlord include a termination clause after one year.

That way, your friend or family member has to sign a completely new lease agreement in their own name if they want to stay, rather than the existing lease automatically rolling over to a month-to-month contract.


If You Don’t Cosign: Alternatives to Cosigning

Just because you turn down your friend or family member for cosigning their loan doesn’t mean you can’t help them otherwise.

As you mull over the decision, consider a few alternative ways you might help them get on their feet financially without exposing yourself to so much credit risk.

Help Them Create a Budget

Public schools don’t teach personal finance, budgeting, or investing. If your friend is in the position of having to ask for a cosigner, chances are they never learned these skills — especially how to create a budget.

They could try to figure it out on their own. Or you can vastly improve their odds of success by helping them clean up their finances and budget.

As they increase their savings rate, several stars begin aligning in their favor.

First, it helps them pay down any existing debts, which may be hindering their ability to take out a loan on their own. Second, it helps them save money faster that they can use toward a down payment on a loan.

And the larger their down payment or cash reserves, the more likely lenders are to offer them credit, regardless of the type of loan.

Help Them Build Their Credit

Help your friend or family member automate their debt repayments, setting up recurring payments on each payday. Offer to physically take their credit cards and store them somewhere safe. Explain that their credit score will rise if they can get all balances below 30% of the accounts’ credit limits.

Serve as an accountability partner, having them report back to you about whether they paid every single one of their bills on time each month. Review their credit report with them, and help them dispute any errors you find. Have them establish good credit safely with a secured credit card.

In short, keep working on their credit with them until they become creditworthy in their own right.

Just Give Them Cash

Another option is simply giving a loved one cash toward their down payment. It poses far less risk to you: less risk to your credit, less legal liability, and less money on the line.

It could be a straightforward gift, something to help them qualify for the loan with a larger down payment. Or you could attach a few strings, as you see fit.

What you can’t do is lend someone the money for a down payment on a home. Mortgage lenders don’t allow any part of the down payment to be borrowed. As soon as they see a large deposit in your friend or family member’s bank account, they’ll demand an explanation, then require a signed letter from you declaring the money is a gift that doesn’t need to be repaid.

A gift to a friend or family member with no strings attached offers fewer complications for your relationship. Alternatively, you could ask them to pay you back in other ways, such as mowing your lawn, babysitting for you, or dropping off precooked meals.

Offer Collateral Instead of Cosigning

This option still puts you at risk, but at least it limits that risk to one specific asset.

If your friend or family member wants a car loan, offer to put up your car as additional collateral. If they’re applying for a mortgage, offer a lien against your home as extra collateral. This will reduce the risk to a lender enough that they may be willing to give a loan to your loved one without requiring a cosigner.

Granted, if your friend or family member defaults on their loan with your property as collateral, you’d lose your car or home. So you still have to monitor their loan payments and potentially nag them or step in to make payments on their behalf, but at least you don’t risk your credit or any other assets.

Open Your Doors to Them

If your friend or family member is recovering from a divorce or other major financial catastrophe, you can always let them come stay with you for a little while rather than cosigning a loan or lease for them. If they need a car, perhaps offer them use of yours rather than cosigning a car loan.

The inconvenience may not be fun, but it’s often better than cosigning for them.

Lend Them the Full Amount Yourself

Finally, you could offer to lend them the money yourself.

No one says you can’t give them a car loan, or a home mortgage, or a business loan. Just make sure you attach a lien against the collateral and prepare yourself for the possibility that you might have to foreclose or repossess the collateral through legal action if they default on the loan.

At least you don’t risk your credit or legal liability. And perhaps you can even earn a return on the interest for your trouble.


Final Word

Someone in need of a cosigner may beg and plead for your help. And if you respectfully decline the enormous favor they’re asking, they might try to make you feel guilty.

Ultimately, though, it’s your credit on the line. You’ve spent years building an excellent credit history, and it only takes a few missed payments to undo your hard work and reduce your ability to qualify for low rates — or get any financing at all.

Never casually agree to cosign a loan or lease. If someone asks for your help, tell them you need a few days to mull it over. Evaluate the decision carefully, and recognize the very real risks that come along with the borrower defaulting and leaving you holding the loan.

If you have even the slightest doubt about your friend or family member’s ability to make all payments on time, consider the alternatives above. Or simply tell them that as much as you love them, it’s a favor you simply can’t grant right now.

They may be upset momentarily, but it’s better to endure a one-time flare of anger than years of resentment, mistrust, and nagging.

G. Brian Davis
G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.

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