At some point in your life, you may be approached by a friend or family member asking you to co-sign for a credit card. While this is a common enough agreement between parents and their children, or very close relatives, it can be a pretty bad idea.
Co-signers can help those with limited or no credit qualify for loans and credit cards. By piggybacking on your established credit history, they have access to financial products that may otherwise be out of reach. At first glance, signing a piece of paper to help a loved one may seem harmless and even admirable. If someone asks you to co-sign, they are probably not looking to intentionally wreak havoc on your finances. Unfortunately, life happens, and their mistakes and misfortunes will become your own.
Co-signing can land you in debt
When you co-sign for a credit card, you take full responsibility for every dollar charged to that little piece of plastic. Lenders distribute loans based on creditworthiness, or how likely you are to make payments on time based on your income, savings and borrowing history. If a person cannot qualify for a financial product, it is because the lender is not convinced the borrower will have the means to maintain a responsible repayment schedule. And if the lender is not convinced, you shouldn’t be, either.
If you’re confused about your responsibilities as a co-signer, think of it this way. You are signing up for a regular card for which you must pay debts, interest rates, late fees and overlimit fees. The only difference is somebody else is allowed to make purchases without your approval. Pretty terrifying, right? If the other person defaults or declares bankruptcy, you are legally obligated to repay what is owed. Simply enough, their debt becomes your debt.
Co-signing can destroy your credit score
Activity on the credit card will directly impact your credit score. While the act of co-signing a card doesn’t damage your credit score, your partner’s irresponsible usage can destroy the credit history you worked hard to build. Lenders and credit bureaus will view the account activity as equally yours–even if you had nothing to do with it. Your partner’s late payments will destroy your credit score.
Another major factor that determines your score is your credit utilization ratio. Your credit utilization ratio is your total credit used compared with your overall credit limit. Experts recommend staying under 30%. If the cardholder starts racking up debt, your credit utilization ratio will be negatively affected. For example, let’s say you have 3 credit cards with a combined limit of $15,000. You do a pretty good job of keeping your credit card debt around $3,000, putting your ratio at 20%. But now you’ve co-signed for a card with a $5,000 limit and the cardholder has already run up $4,000 in debt. Your credit utilization just shot up to 45%. That’s going to have a tangible impact on your credit score.
Co-signing can ruin relationships
Sharing finances is a dangerous game. People co-sign with the expectation that both parties will practice responsible spending. The fact of the matter is, not everyone has the willpower, education and good fortune to keep their finances in manageable order. Any number of life events can send your finances into a downward spiral. From medical emergencies to a lapse in judgment, there are always possibilities lurking around the corner. If your co-signing arrangement turns sour, your relationship with that person may be damaged beyond repair. The strain of a financial relationship can be enormous. Don’t risk it!
Alternatives to co-signing
Instead of co-signing for someone, suggest an alternative. Two common options are adding the person as an authorized user or having them apply for a secured credit card. When you take on an authorized user you maintain control over the credit limit and can take the person off your card at any time. You’ll still be responsible for the bill, but this options comes more safeguards against abuse. And as long as you keep account activity under control, the card should have a positive effect on both your credit scores.
A secured credit card is great way for a person with limited credit to build a credit history. Secured cards function similar to regular credit cards, but the cardholder is required to put down a security deposit that determines the account limit. You’re essentially borrowing from yourself, so the cards are issued at no risk to the lender. That means almost anyone can get approved. Secured credit cards are perfect for someone who is just starting to build a credit history.