What you should know before co-signing a loan
Co-signing can be viewed as a gesture of support, helping someone qualify for a loan when they might not meet the eligibility criteria on their own. It can be a way to provide financial support to loved ones, but it is important to understand its potential impact on the co-signer as well.
In this guide, we’ll explore the benefits, potential downsides and rights and responsibilities involved in co-signing.
What is a co-signer?
A co-signer is someone who agrees to share financial responsibility for a loan or credit agreement with the primary borrower. It can be used to assist a family member or friend who may not qualify for a loan on their own because of limited credit history, lower income, or poor credit.
The benefit of co-signing a loan
Co-signing offers tangible benefits for the primary borrower, particularly for those with limited credit history or financial constraints. Whether it's a student loan, a mortgage, or financing for a car, having a co-signer can help a borrower access more funds or enjoy lower interest rates. Co-signing can be a powerful tool if the primary borrower is trying to build or repair their credit history.
Potential risks of co-signing a loan
If you are considering co-signing a loan, it is important to consider the potential risks. Co-signing a loan means that you are taking on legal responsibility for repaying the debt if the primary borrower fails to make payments. Your credit score will be affected if the principal borrower misses or makes late payments.
It’s important to understand your own financial situation, the borrower's reliability, loan terms, credit implications, and your capacity to take on these risks. Before co-signing on a loan, consider:
- Financial responsibility: When you co-sign a loan, you are equally responsible for repaying the outstanding loan amount. If the primary borrower defaults or misses payments, you are legally obligated to step in and cover the payments. If you cannot make the payments, you may face collection efforts and potential legal action by the lender.
- Credit impact: Co-signing a loan can impact your credit score. Any late payments or defaults by the borrower will be reflected in your credit report, potentially lowering your credit score and affecting your ability to secure credit in the future.
- Strained relationships: Money matters can strain relationships. If the borrower encounters financial difficulties and you must assume the loan responsibility, it could lead to tension or conflict within your personal relationships.
- Limited control: As a co-signer, you typically have no control over how the loan funds are used. You are responsible for the debt but may not benefit directly from the loan. However, co-signers have the right to request information about the loan's status, which may allow you to monitor the loan's status and address any delinquency with the borrower.
- Impact on your debt-to-income ratio: Co-signing can affect your debt-to-income ratio. Your debt-to-income (DTI) ratio shows what percentage of your income goes to debt repayment. A high DTI may impact your ability to qualify for your own credit in the future.
- Long-term commitment: Co-signing often involves a long-term commitment, such as a mortgage or student loan. You could be tied to the loan for many years, limiting your financial flexibility.
- Difficulty in removing your name: It can be challenging to remove your name as a co-signer from an existing loan. The primary borrower would need to qualify for refinancing or pay off the loan entirely to release you from the loan.
- Uncertain outcomes: Economic or life circumstances can change unexpectedly. Job loss, health conditions, and other situations can affect the borrower’s ability to make payments, or the co-signer’s ability or willingness to take on risks involved in co-signing.
What happens to assets if the loan isn’t paid off?
A lender may take back ownership of an item if they are not receiving payments on it – called repossession. This can happen on any item that was used as collateral/security or bought on credit, like cars, homes, furniture and electronics.
For example, if a person defaults on their car loan payments, the lender may take the vehicle and sell it at auction to cover some of the remaining loan balance. Repossession allows banks or other authorities to claim ownership of an asset.
After the lender repossesses and sells the asset, there may still be some money left to pay on the loan. In this case, the borrower and cosigner are still responsible for the remaining balance. The balance could include repossession costs, interest, penalties and other fees outlined in the terms of the loan agreement.
Before you sign
If you choose to co-sign a loan, it’s important to understand the terms and conditions of the loan. Be sure to read through the documentation provided before signing anything. Have an open conversation with the borrower about their financial commitments and make sure everyone understands their obligations. Ensure you are making the decision based on your own genuine desire and ability to help, not because you’re feeling pressured or forced. If you are unsure about co-signing or if you are feeling pressured, it might be a good idea to seek guidance from a financial advisor or legal professional.
While it's nice to lend a hand to someone you care about, it's important to understand the obligations involved and the potential impact on your own financial situation.