Learn How Co-Signing a Loan Can Affect Your Credit
When you co-sign a loan for somebody, you promise to repay the loan if the other borrower stops making payments. Usually, this is something you do because you have better credit scores and income than the borrower, but co-signing can also affect your credit.
Depending on how things go, co-signing for a loan can help or hurt your credit scores. Of course, the worst thing that can happen is late or missed payments on a loan you’ve co-signed for.
Your Credit Reports
When you co-sign, that loan should appear in your credit reports. After all, you’re 100% responsible for repaying the loan – just like the person you’re helping – even if you don’t intend to make any payments.
Credit reports help lenders understand how much you might potentially owe, and there’s a very real possibility that you’ll have to pay off any loans you co-sign on (the borrower might be responsible, but things happen – job losses, natural disasters, and auto accidents could take away the borrower’s ability to repay).
This potential debt burden might make it harder for you to borrow.
Credit scores evaluate several criteria, and your scores will be affected when you co-sign. For example, the Amounts Owed category in your FICO credit score – which makes up 30% of your score – looks at:
Co-signing will affect all of those factors – not necessarily in a good way. If you have solid credit (for example, you’ve got a FICO score above 800 and you’ve had good credit for years), the effect might be minimal. But if you have “thin” credit or have never established credit you’ll want to be careful. That said, co-signing for a loan can help you build up your credit – see below.
It’s not impossible to borrow after you’ve co-signed, but you reduce your borrowing ability. Lenders evaluate how likely you are to repay based on several factors in addition to your credit score. For example, they look at how much of your monthly income is available to pay off new loans (your debt to income ratio). A loan you’ve co-signed for will reduce the lender’s view of how much you can afford.
The Good News
On the bright side, co-signing for a loan can help you improve your credit. This is especially true if you’ve never used credit in the past or you’ve got a few negative items in your credit history.
When loans get paid off on time, your credit improves. Being associated with (and responsible for) a loan that gets paid off successfully can only help. However, if there are any late payments – or if you and the other borrower(s) default on the loan – you’ll pay the price as if you were solely responsible for the loan.
Another way that co-signing helps you build credit is in the Credit Mix category of your FICO credit score. While this category only makes up 10% of your score, every little bit helps. The Credit Mix category looks at which types of loans you’ve used.
If you only borrow with credit cards (or co-sign for credit card accounts), you won’t get much improvement. But if you’re associated with other installment loans like auto loans and home loans, you’ll improve the mix of accounts in your credit reports – and that’s a good thing.
The Most Important Thing
Whether your concern is about avoiding damage to your scores or improving your credit, the most important thing is that all payments get made on time. If you’re a co-signer, this is very much your business (and your problem if it doesn’t happen). Late payments will damage good credit and significantly delay any success you’re having with building credit.