When you co-sign a loan, you promise to pay off somebody else's debt if the borrower stops making payments for any reason.
This is a generous act, as it can help a friend or family member get approved for a loan that they otherwise wouldn’t qualify for. But it’s also risky to guarantee a loan for somebody else.
Learn what happens when you co-sign and loan and the risks it can create for your own financial stability.
What Does It Mean to Co-Sign?
A co-signer helps a borrower get approved by adding their name to the application.
This is different from being a co-applicant; a co-signer is not applying to use any of the money in the loan. Instead, the co-signer guarantees that they will repay the loan if the borrower stops making payments or defaults entirely.
In addition to being responsible for repaying the loan if the borrower cannot or does not, a co-signer may also have to repay:
- Late fees
- Collections fees
Co-signers are necessary when the borrower is unable to qualify for a loan on their own. There are different reasons this might happen, such as:
- Not enough income to cover loan payments
- Poor credit
- History of bankruptcy
- Lack of borrowing history
Co-signers typically have enough income and sufficient credit scores to strengthen the loan application. With the co-signer involved, lenders may decide to approve an application.
The Risks of Co-Signing
Helping a family member (or a very close friend) qualify for a loan comes with risks. It's important to understand what those risks are before you agree to become a co-signer.
Damage to Your Credit
If the borrower does not repay the loan as agreed, your credit suffers along with the primary borrower’s credit. Late and missed payments appear on your credit reports, which will cause your credit scores to fall. As a result, it gets harder for you to get loans, and there may be other consequences (like higher insurance rates).
If you co-sign for a loan, lenders will expect you to come up with the required payments, plus any additional interest and fees.
It doesn’t matter if the borrower has more money than you do or is able to pay but doesn't. The lender collects wherever possible, and they take the path of least resistance. You agree to put yourself into the mix when you co-sign, and it might be easier to get funds from you.
In some states, it is legal for the lender to try to collect from a co-signer before a borrower. This means you might be asked for payments before the person who actually borrowed the money.
It also doesn’t matter why the borrower isn’t paying. They might lose a job, pass away, become disabled, or simply disappear. The payments must still be made, and the lender will expect you to do so in full.
If you don’t make payments, lenders may bring legal action against you. Those attempts to collect also appear on your credit reports and do further damage. What’s more, lenders may be able to garnish your wages and take assets from your bank account if you don’t willingly make payments.
Reduced Ability to Borrow
When you co-sign a loan, other lenders see that you are responsible for the loan. As a result, they assume that you’ll be the one making payments.
Co-signing reduces the amount of your monthly income that is available to make payments on new loans. Even though you’re not borrowing—and even if you never have to make a single payment on the loans you co-sign for—it’s harder for you to qualify for another loan in your own name.
This can prevent you from accessing money, such as a mortgage or a car loan, when you need to.
Losing Personal Property
If you pledge any personal property as collateral for the loan, such as a car or valuable jewelry, you can lose that property. If the borrower defaults and you are unable to make payments, the lender can claim whatever property you put up as collateral.
No Easy Out
When you co-sign, you enter into a long-term relationship. Lenders will reluctant to let you off of the loan because that decreases their chances of being repaid.
It is possible to remove yourself from the loan (or get a co-signer release) in some cases, but this can be a complex process that doesn't always work. More likely, you will continue to be a co-signer until the loan is fully repaid.
When you co-sign, you become responsible for the debt only. You don’t own whatever the borrower buys, and you have no right to the property just because you co-sign.
If a borrower stops making payments, there might be legal procedures you can follow to regain some of what you lose. However, that process is complicated and not always successful. You may not be able to regain the full amount you lost.
When you co-sign for a loan, you are taking on all the risks of borrowing with none of the benefits.
When Should You Agree to Co-Sign for a Loan?
In some situations, it may make sense to become a co-signer for an adult child, partner, or another close relative. But how do you know when it's a good idea?
You Can Afford the Risk
You should only agree to co-sign for someone else's loan if you can afford to lose the entire amount that needs to be repaid. This might be the case if you have plenty of extra cash flow and substantial assets available to pay off a loan if your borrower defaults.
You will still need to verify that you will have the income and assets to qualify for any potential borrowing of your own. Remember that while you might be able to afford the risk now, you need to be able to absorb losses at an unknown time in the future, as well.
You’re In It Together
You should only become a co-signer for someone that you completely trust. This is easier if the loan can benefit you both.
If you’re essentially borrowing with somebody, it could make more sense to co-sign. For example, you might be buying a car that will be part of your household, and your partner needs a little boost to get approved. That said, it might be better to be a co-owner of the car and apply for the loan jointly.
You Truly Want to Help
In some cases, you may just want to help somebody else. Co-signing can pose substantial risks, but you may be willing to take those risks.
Sometimes things work out fine, especially when you are co-signing for someone whose financial situation you know and trust. However, you still need to be prepared for things to go badly.
Alternatives to Co-Signing
Before you co-sign, evaluate the alternatives. There are other choices for sharing some of the burden of a loan that can keep everybody's finances safe and secure.
Help With a Down Payment
Instead of co-signing so that lenders approve your borrower, help out with a down payment instead. A bigger down payment could result in lower required monthly payments—making it easier for the borrower to qualify with limited income.
For this option, you need to:
- Have substantial cash on hand
- Be willing to lose that money
- Communicate about how to handle the down payment
Discuss whether or not you’re making a gift, and if you need to set up a formal private loan agreement. Check with a CPA and attorney to identify and avoid any potential issues.
If you are helping with a down payment, some lenders may require you to submit a "gift letter," which states that the amount you are contributing doesn't need to be repaid.
You can lend the money yourself if the borrower can't otherwise get approved and you don't want to co-sign. This is called a private loan, where you are the bank.
If you go with the option, be sure that you:
- Can afford to lose the money
- Communicate clearly about expectations
- Get the loan agreement in writing
There are downsides to private loans, however. Loaning money between family and friends can make personal relationships awkward, especially if the borrower has trouble repaying. Private loans can also make it difficult for the borrower to build credit unless you report payments to credit bureaus.
Tips for Becoming a Co-Signer
If you decide that co-signing makes sense for you, manage the risks to protect yourself and your relationship. Don't be surprised if you have to pay: many co-signers end up repaying all or part of a loan.
- Communicate: Stay in close contact with the primary borrower, and encourage communication early and often.
- Get info: Get access to all the loan paperwork and payments. Request that the lender informs you of any late or missed payments, or if the terms of the loan change.
- Keep current: If the borrower starts missing payments, make payments yourself to keep the loan current to avoid damage to your credit. You’ll also want to find out what’s going on with the borrower and get them back on track.
- Manage the risk: When the goal is simply to help somebody build credit, manage your risk by keeping the loan small and short-term. A small loan you can easily pay off that’s due within a year or eighteen months will require less of your time, energy, and financial investment.
- Get released: Some loans allow a co-signer to be released after the borrower meets certain conditions, such as making on-time payments for a certain amount of time. Take advantage of this opportunity as soon as possible to protect your own finances.
Helping somebody get a loan is a generous gesture, but it’s critical to understand the risks before doing so. There’s a reason a lender wants a co-signer: they aren't confident that the primary borrower can repay in full and on-time.
If a professional lender isn’t comfortable with the borrower, you need to have full trust in them, and the ability to repay the loan yourself if they cannot, before you take on the risk of co-signing someone else's loan.