An internet search of the term “cosigning a loan” quickly reveals it's a terrible idea. And there are valid reasons for much of the negativity.
Helping a family member or a friend by cosigning a loan is incredibly helpful for them, but significant problems arise for a cosigner when they don't know or understand what they agreed to.
Many people cosign without understanding how the loan may impact their own finances. And worse yet, some people aren't fully prepared to pay the loan back if the primary borrower quits paying.
There are some valid reasons to consider cosigning some types of loans. And plenty of people cosign loans without running into problems.
Let's take a look at what exactly cosigning means, what are a cosigners rights, and the impact it can have on your own finances. Then we'll discuss when cosigning makes sense and when to avoid it at all costs.
What is Cosigning and Who Needs a Cosigner?
People need loan cosigners for a variety of reasons. Having a low income, lacking a credit history, or having a poor credit history (late payments or defaulting on payments) are all reasons lending institutions deny people loans.
Individuals in these situations may qualify for loans if they can find a cosigner meeting the requirements of the lender.
When someone cosigns a loan, they aren't just lending a good credit score to boost the chances of loan approval. They're agreeing to pay the loan in full if the primary borrower doesn't pay.
The cosigner also has to understand they may have no rights to whatever they are cosigning for.
An example is cosigning for a car. If the primary borrower defaults on the car loan payment, the cosigner is still responsible for the loan. But they usually aren't the owners of the car, unless they also list their name on the vehicle's title.
Keep in mind cosigning doesn't equal ownership in most cases and therefore no rights to the property. Clarifying the point you absolutely need to know what you agree to if you cosign for a loan.
How Can Cosigning Impact Your Credit?
Cosigning for a loan may not impact your finances at all if loan payments are made on time each month. And if you don't need new credit yourself.
In fact, you could even see a small increase in your credit score depending on the circumstances. But it is much more likely to impact your credit negatively instead
If the primary borrower fails to make a payment, you have to make the payment or risk damaging your credit.
If you haven't carefully planned for this in your budget, you may have to make the loan payment and then pay interest on a credit card you can't pay off at the end of the month. This can also increase your credit utilization and drop your credit score.
Cosigning may also affect your approval for new credit cards, lines of credit, or another loan for yourself. A lender will consider the loan you cosign for as your own debt when looking at your ability to pay for any new loans you may want.
If you believe the old saying “time is money” then the time monitoring the primary borrower's payments and your own credit score comes at a cost. And remember the bigger any default issue becomes, the more time and money it will take to solve.
Other Reasons for Saying No to Cosigning
As tough as it might be to say no to your kids, relatives, or friends – saying no to cosigning a loan may not only be in your best interest, but it may help them from making a big financial mistake.
People require a cosigner when not qualifying for a loan for the reasons above. If the lender is questioning their ability to pay back the loan, you should too.
In addition to the possible negative credit impacts, you could be sued before the primary borrower if payments aren't made on a loan. This may come as a surprise to those who cosign loans.
You could also be forced to take legal action against the primary borrower if you end up paying off a loan they default on and want your money back.
Having to pay taxes on any loans settled on is an additional expense a cosigner might not consider when agreeing to back a loan for someone.
In addition to footing the bill for a loan that may be defaulted on, the above are good reasons to say no when asked to cosign a loan.
If the person asking you to cosign has little to no income and struggled to keep a job or pay bills on time in the past, it might make more sense to offer to pay a few of their bills for some time or help support them in another way.
Depending on your skillset, your relationship with them, and their willingness to learn, you could help them with a job search or do mock interviews to improve communication skills.
If you've mastered budgeting, show them your spreadsheets or your favorite budgeting app.
Helping them find solutions for cutting back monthly expenses can put money back in their pocket too.
When Cosigning Might Make Sense
It can be a reasonable decision to cosign a loan if:
- you understand the terms of the loan,
- you are in a financial position to pay off the loan
- and if the loan won't interfere with meeting other financial goals you've set
A parent may cosign a car loan for their child if they need a car to get to work. The parent may also use the loan to help teach their child better understand loans and the payments and responsibility coming with them.
Cosigning for private student loans may reduce the interest rate your child has to pay on loans for their education and boost their credit score if regular on-time payments are made. But there are a lot more things – including your relationship with your child – you should consider before making this decision.
Federal student loans with lower interest rates and no requirements for cosigners should be their first loan option. For a detailed guide on taking out student loans, check out this article on Credible.com.
Is it Possible to Get Out From Under a Co-Signed Loan?
It's possible but difficult.
Obtaining a co-signer release can remove a co-signer from the financial responsibility but in order to obtain one, specific conditions (i.e. a number of on-time payments or a certain amount paid) must be met by the primary borrower first.
It’s entirely up to the financial institution who provided the loan as to whether you can be removed as a co-signer.
The lender will want to ensure the borrower has the income and proven payment history to handle the loan on their own.
Co-signers have very few rights (if any) once the loan is secured since when you agree to co-sign, you're signing up to pay if or when the primary borrower doesn't. If you're not able to obtain a co-signer release, you're stuck.
Take Care of Yourself First
As much as you may want to help a family member or friend obtain a loan, put your own finances first. Even people you trust may end up in a situation where they can't make loan payments.
If you're considering cosigning a loan, make sure you could pay it off without dipping into your emergency fund or by going into debt yourself.
One of the big things people who cosign loans don't realize is that their relationship with the family member or friend can be forever changed by a loan.
Saying no to cosigning a loan may be difficult, but maintaining a good relationship with someone who has hurt your credit score and cost you thousands of dollars will be much harder than you think.
Take care of yourself and make sure you consider every option available before you agree to cosign a loan.
Vicki and Amy are authors of Estate Planning 101 – a Crash Course in Planning for the Unexpected -coming soon from Adams Media.