If you have a good credit rating, you may be asked at some point to co-sign on a loan for someone else. For example, your child may need help getting their first credit card, or a friend may require a co-signer for a car loan. Before you sign on the dotted line, however, you need to consider the pros and cons associated with co-signing.
Understanding the Responsibility of a Co-Signer
Before you co-sign, you should understand what it entails. When you co-sign on a loan, you are pledging yourself to pay on the loan if the borrower doesn't pay. The main advantage of co-signing is that you can help someone else get the credit he or she needs. For example, co-signing for your child can help them get started down the path to good credit. Your signature on the loan provides someone else a chance since your good credit history offers reassurance to the lender that the debt will be repaid.
There is, however, a downside. You should realize that you will be held responsible for a co-signed loan if the borrower doesn't pay. When the borrower misses a payment, the creditor can come after you because you agreed to be legally and financially responsible for the loan.
For many people, this aspect of co-signing is enough of a drawback to avoid it altogether, even if it will help someone out. Not only does the debt show up on your credit report, but it also influences your debt-to-income ratio, should you need to borrow money for yourself (as the co-signer) in the future. The act of co-signing essentially limits how much credit you can potentially use, which makes up 30% of your own credit score.
If a co-borrower defaults, the kind of collection actions a creditor can take against a co-signer include reporting the defaulted account to the credit bureaus, pursuing a civil judgment and if a judgment is obtained, garnishing wages or bank accounts.
Aside from potentially facing collection actions, there can be another negative consequence in the form of credit score damage. Since the co-signed loan is in your name, it also shows up on your credit report. If the co-borrower misses a payment or defaults altogether, the lender can report that negative account activity on your credit. The end result can be serious damage to your credit score that could make it more difficult for you to qualify for loans and receive the best interest rates.
Gauge Your Trust Level in the Borrower Before Co-Signing
Before you agree to co-sign a loan, ask yourself how well you trust and know the borrower. Do you believe that they will make their payments to the loan on time? Have they demonstrated a previous history of using credit responsibly? What about personally? Do they have a history of following through on their obligations or have they broken their word at any point in your relationship? These aren't necessarily pleasant thoughts to have, but they're necessary for protecting yourself from having to pay off a debt that you co-signed for.
Consider If Co-Signing on a Loan Could Negatively Impact the Relationship
Additionally, you need to weigh the potential impact co-signing the loan might have on your relationship with the borrower. Will you be constantly nagging the borrower to make sure that they fulfill the obligation? What happens if the borrower defaults?
When it is your own child or a parent, it might be easier to get past having to pick up the slack on an unpaid loan. However, when it is a friend or sibling that fails to pay, sticking you with the bill can cause an irreparable breach.
One of the biggest disadvantages to co-signing a loan can be the effect it has on a cherished relationship. If you are concerned about this, it might be better to consider other ways that you might help someone who is in a bind.
If you do decide to co-sign on a loan, consider drawing up a written promissory note that would obligate the co-borrower to repay any financial losses you incur as a result of them defaulting on the loan.
The Bottom Line
Co-signing on someone else's loan is a big commitment. Before you agree to it, you need to weigh the pros of helping someone get a loan they might need against the cons of possibly getting stuck paying for a debt you didn't incur. It's a tough decision and one that shouldn't be made lightly.