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Cosigning a Loan – Understanding the Reasons & Risks

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There’s 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.

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:

Understand 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.

Cosigning Make Sense

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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