You may be asked to co-sign a loan by your spouse, child or friend, especially if your credit score outshines theirs.
But what sounds honorable — you helping someone get money for a new home or college tuition — can have consequences you may not expect.
What is a co-signer?
A co-signer is someone who adds their name to the primary borrower’s loan application, agreeing to be legally responsible for the loan amount, and any additional fees, should the borrower be unable to pay.
Most people want or need a co-signer because they can’t qualify for the loan by themselves. If you have a strong financial profile, co-signing for someone with a lower credit score or thin credit profile can improve their odds of qualifying or snagging a lower interest rate.
Unlike a joint loan in which two borrowers have equal access to the loan, in a co-signed loan, the co-signer has no right to the money even though they could be on the hook for repayment.
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Risks of co-signing a loan
Co-signing on someone else’s loan puts you in a uniquely vulnerable position. Here are the risks and benefits to consider, as well as how to protect your finances and your relationship if you choose to co-sign.
1. You are responsible for the entire loan amount
This is the biggest risk: Co-signing a loan is not just about lending your good credit reputation to help someone else. It’s a promise to pay their debt obligations if they are unable to do so, including any late fees or collection costs.
Before you co-sign, assess your own finances to ensure you can cover the loan payments in case the primary borrower cannot.
2. Your credit is on the line
When you co-sign a loan, both the loan and payment history show up on your credit reports as well as the borrower’s.
In the short term, you’ll see a temporary hit to your credit score, says Bruce McClary, spokesperson for the National Foundation for Credit Counseling. The lender’s hard pull on your credit before approving the loan will ding your score, he says, and so could the increase in your overall debt load.
Most important, though: Any missed payment by the borrower will negatively affect your credit score. Since payment history has the biggest influence on credit scores, a misstep here can wreck your credit.
3. Your access to credit may be affected
The long-term risk of co-signing a loan for your loved one is that you may be rejected for credit when you want it. A potential creditor will factor in the co-signed loan to calculate your total debt levels and may decide it’s too risky to extend you more credit.
McClary recommends checking your credit report regularly after co-signing to keep an eye on your finances.
4. You could be sued by the lender
In some states, if the lender does not receive payments, it can try collecting money from the co-signer before going after the primary borrower, according to the Federal Trade Commission.
To get to that stage, the borrower would likely have missed several payments, and the debt would already have started to affect your credit. Lenders are likely to consider legal action when the debt is between 90 and 180 days past due.
If the worst happens and you are sued for nonpayment, you’re responsible as the co-signer for all costs, including attorney’s fees.
5. Your relationship could be damaged
The borrower may start out making full, on-time payments toward the loan or credit card with good intentions. But financial and personal situations change.
Children who run into trouble with payments toward a co-signed credit card or car loan may hide the shortfall from their parents until the situation worsens, ruining trust in the relationship.
Couples going through a divorce often have to deal with the financial consequences of a co-signed car or mortgage, says Urmi Mukherjee, a certified financial counselor at Apprisen, a nonprofit financial counseling agency. In those cases, it may be tough to persuade one spouse to pay his or her share, especially if the spouse has moved out of the house or given up the car.
6. Removing yourself as a co-signer isn’t easy
If issues arise, removing yourself as the co-signer is not always a straightforward process.
Refinancing the loan is one way to have yourself removed, provided that the primary borrower can now qualify for a new loan on their own. Student loans or credit cards typically require a certain number of on-time payments before the lender will reassess the primary borrower to see if they can make payments on their own.
Benefits of co-signing a loan
The upside of co-signing a loan for someone is obvious — you can help them qualify for college tuition, a credit card or some other financial product they could not get on their own, or save them interest with a lower rate.
When someone is new to credit or is rebuilding their finances, having a co-signer with a good score and an established credit history is powerful.
Not all online personal loan lenders allow co-signers, so it’s worth checking before you apply.
Does co-signing a loan build credit?
Being a co-signer can build your credit in these ways:
As long as payments are made on time, it adds to your payment history. However, if you have a good score and well-established credit, the effect may be small compared with the danger to your score if the borrower doesn't pay.
You might get a small benefit if your credit mix improves. It's useful to have both installment loans (with level payments) and revolving accounts (like credit cards).
The person you co-signed for can build their credit in these ways:
It can help them qualify for credit they otherwise would not get, boosting a thin credit file.
Making on-time payments on the account builds up a good payment history.
How to protect your credit if you co-sign a loan
Before you co-sign, ask the lender what your rights and responsibilities are and how you’ll be notified if payment issues arise.
In addition, ask the primary borrower for access to the loan account so you can track payments, says Byrke Sestok, a certified financial planner at New York-based Rightirement Wealth Partners.
“It’s not a trust issue — problems happen,” Sestok says. “If you find out in the first month that someone is having a problem [paying back the loan], you can do something about it.”
To plan for such occurrences, establish an arrangement between co-signer and borrower upfront and in writing that spells out expectations for each person, McClary says. Your private agreement will help smooth out mismatched expectations, he says.
Alternatives to co-signing a loan
If you don’t want to co-sign a loan, there are other options available for the borrower:
Apply for a bad credit loan: There are online lenders that work specifically with applicants who have bad credit. These lenders have looser requirements than banks and will evaluate other factors besides credit score. However, interest rates at online lenders can be high if you have bad credit, with annual percentage rates typically above 20%.
Offer collateral: A borrower might be able to offer big-ticket items like their home, car or even an investment or savings accounts as collateral on a loan. This is known as a secured loan and comes with its own risk. If the borrower is unable to make payments on the loan, they will lose whatever asset they’re pledging.
Try a family loan: If the borrower was hoping to have a family member co-sign for them, they could opt for a family loan instead. A family loan doesn’t involve a third-party lender, so there’s no formal application or approval process, but it should include a notarized, written agreement between the two parties summarizing terms. Family loans can help borrowers get cheaper loans and avoid predatory lenders, but they still put another person’s finances at risk should the borrower be unable to repay the loan.