The Pros and Cons of Cosigning Loans
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When a friend or relative asks you to cosign a loan, your first instinct may be to agree and help them out of a tight financial spot. That’s understandable: When done responsibly, cosigning can be an invaluable tool for helping a loved one with poor or limited credit history gain access to the housing or credit they need. However, before you pick up that pen and sign on the dotted line, be sure you know how attaching your name to someone else’s debt may potentially impact your own finances.
What does it mean to cosign a loan?
Cosigning for someone means you’re taking responsibility for the loan, lease or similar contract if the original borrower is unable to pay as agreed. Whatever you cosign will show up on your credit report as if the loan is yours, which, depending on your credit history, may impact your credit scores.
Cosigning a loan doesn’t necessarily mean your finances or relationship with the borrower will be negatively affected, but it’s not a decision you should make lightly. Before you agree to help out, sit down with the borrower to discuss the situation and the borrower’s plan to keep up with their financial obligations. Make sure you both understand what is required of you as the cosigner, and together weigh the pros and cons of this action on your relationship. Take special care to discuss what will happen should the borrower be unable to keep up with their payments as agreed and ensure they understand how you may be affected as well.
The benefits of cosigning a loan
Clearly, cosigning a loan is most beneficial for the individual for whom you agree to cosign. It can be a great way, for example, to help your child build credit. When a young adult is just starting out, it can be hard to get a loan or credit card with a decent interest rate because they lack the credit history that lenders use to determine if a prospective borrower is reliable. Cosigning for your child allows them to start building the credit history they need while reassuring the lender that they’ll get repaid.
Possible disadvantages of cosigning a loan
By cosigning for another individual—child or otherwise—you are putting yourself on the line for that person’s loan. If the borrower is responsible in their repayment habits, there should be no negative impact on you, but if you find that is not the case, you could be seriously affected:
- It could limit your borrowing power. Potential creditors decide whether or not to lend you money by looking at your existing debt-to-income ratio. Depending on how much debt you already have, the addition of the cosigned loan on your credit reports may make it look like you have more debt than you can handle. As a result, lenders may shy away from you as a borrower.
- It could lower your credit scores. Because that debt shows up on your credit reports as if it were your own, your credit scores will be affected by any late or missed payments. If the borrower stops paying altogether and the loan goes into collection, that could also go on your credit reports, and the bill collectors could come after you to get their money. Lenders or collectors could even sue you, garnish your wages or put a lien on your property in an effort to collect the balance of the debt.
- It could damage your relationship with the borrower. You should also consider how cosigning a loan might impact your relationship with the borrower. You’ll be tied to this person, and any possible financial upheavals, for the term of the loan, whether that’s six months or 10 years. You’ll be responsible for repayment if the borrower has financial difficulties or if something else goes wrong, and your relationship could suffer.
As with many aspects of personal finance, there’s nothing wrong with helping out a friend or family member in need. Just make sure that you’re ready for any impact on your own financial situation before you lend a hand to a loved one.