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Co-Signing a Loan: Risks and Benefits

Co-signing a loan for someone risks your credit, access to loans and your relationship with the primary borrower. Here’s how to protect yourself if you co-sign.
May 30, 2018
Credit Score, Loans, Personal Loans

You may be asked to co-sign a loan by your spouse, child or friend, especially if your credit score outshines theirs.

Co-signing for someone with a lower credit score or thin credit profile can improve their odds of qualifying for a loan or credit card or snagging a lower interest rate.

But what sounds honorable — you helping someone get money for a new home or college tuition — can have consequences you may not expect.

Here are the risks and benefits to consider before co-signing a loan, as well as how to protect your finances and your relationship if you do.

Risks of co-signing a loan

1. You are responsible for the entire loan amount

This is the biggest risk: Co-signing a loan is not about lending your good credit reputation to help someone else; rather, it’s a promise to pay their debt obligations if they are unable to do so.

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, spokesman 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.

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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, you’re responsible as the co-signer for all costs, including late fees and 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 Kansas City-based financial counselor at Apprisen, a nonprofit credit 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.

When issues arise, removing yourself as the co-signer is not a straightforward process.

Refinancing the loan is one way to have yourself removed, provided the primary borrower qualifies for a new loan on their own. Student loans or credit cards typically require a certain number of on-time payments, and 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 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. The same goes for credit card issuers.

Does co-signing a loan build credit?

Being a co-signer can build credit in these ways:

  • As long as the account is paid 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 credit in these ways:

  • It can help them qualify for credit they otherwise would not get, plumping up 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 and 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.”

» MORE: How to say no to co-signing — and yes to helping

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.

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