Getting approved for a loan can be an uphill climb for borrowers who don’t have the best credit rating. If a lender sees a low credit score, they may be reluctant to green light a loan without having a cosigner on board.
If a friend or family asks you to cosign for a personal loan, car loan or student loan, you may not think it’s that big of a deal but you’re wrong. Co-signing can have some serious financial implications that you should be aware of before you sign your X on the dotted line. If you’re entertaining the idea of becoming a cosigner, here are some import ant realities that you need to understand first.
Reality #1: Cosigning makes you responsible for the debt
One misconception that people tend to have about cosigning is that if they’re not the one using the loan funds, then they’re not the one who’s on the hook for repaying the money. The truth is, when you cosign on a loan or any type of credit for that matter, you’re agreeing to share the responsibility of paying back the associated debt. Essentially, cosigning in the eyes of the lender is the same as taking out the loan yourself.
So what does that mean from a legal perspective? If your cosigner agrees to make the payments but they end up defaulting on the loan, (meaning they don’t pay) the lender can initiate collection actions against both of you to recover what’s owed. Even though you may have had nothing to do with the loan since signing the paperwork, you could become the target of phone calls or letters asking you to pay up.
If your cosigner doesn’t make an attempt to honor their obligation to the lender, the lender can up the ante with a civil lawsuit. The lender can sue both you and the person who asked you to cosign for the outstanding loan balance, plus any late fees or interest charges that have accrued since they defaulted. They can also ask the court to make you pay their attorney’s fees. If the lender successfully proves their case, they can move on to the next step: garnishing your wages or your bank account.
At the end of the day, you could end up on the losing end of a court judgment just for putting your signature on a loan for someone else. While you may have thought you were helping the other person out, you were really just creating financial trouble for yourself.
Reality #2: Cosigning can affect your credit
Cosigning on a loan can impact your credit in a few different ways. First, the lender will have to pull your credit report as part of the loan application process. Hard credit pulls show up on your credit report. Inquiries for new credit count towards your credit score calculation and each inquiry can trim a few points off your score.
If the loan is approved, the account will show up on both your credit reports. That means the payment history and the balance will also be factored into your score. As long as the person you cosigned for is paying the loan on time, then there may not be any negative consequence to your score. If they skip out on paying, however, then you could quickly end up in poor credit territory.
There are several different credit scoring models but one thing they have in common is the fact that payment history carries a lot of weight in score calculations. When you have multiple late payments on your credit because the person you helped to get the loan defaulted, that can wreak havoc on your score. Having an account go to collections or worse–end up as part of a court judgment–can be even more devastating. Negative items can stay on your credit report for seven years, meaning you have to deal with the after effects of cosigning over the long term.
Even if you step in and begin making payments on a loan that the primary borrower defaulted on, you can’t erase any late payments that are already on your credit report. Besides that, having an extra loan on your credit history can also affect your chances of getting approved for new credit down the line. If you’re planning to buy a home, for example, the lender will include the cosigned loan in your debt-to-income ratio (DTI) calculations. If the loan pushes your DTI too high, you could have trouble getting approved for a mortgage.
Reality #3: Cosigning can ruin more than just your credit
There are few things that can sour a relationship faster than an argument over money and cosigning can be a fast track to financial disagreements. If the borrower isn’t holding up their end of the bargain by making the loan payments and making them on time, you may start to resent having cosigned in the first place and before you know it, you’ve wrecked your credit and your relationship.
Adding someone to one of your credit cards as an authorized user is one alternative to consider if they’re simply trying to build credit. Again, though, you have to remember that you’re the one who’s on the hook for any purchases they make. In that scenario, you might suggest that they look into a secured credit card instead. A secured credit card requires a cash deposit up front but you don’t need a cosigner to get approved for one of these cards. That way, there’s no pressure on you to let someone else borrow money based on your good credit.
A good way to think about cosigning is to ask yourself whether you’d be willing and able to make the loan payments if the other person either can’t or won’t. If you’re comfortable shouldering that responsibility, creating some type of accountability or at least making sure that you have full access to the loan account can give you a measure of protection. Just be aware that it doesn’t completely eliminate any risk you may be taking on by cosigning.