Should you Consider Cosigning a Loan?
October 9, 2020 by Daniel Azzoli
When a close friend or loved one reaches out for help, you want to do your best to be there for them. And when things may be dire – like when someone asks you to cosign a loan – your help can go a long way.
But the truth is, when you agree to partially put your financial standing in someone else’s hands, the stakes can be high. There can be serious risks that come with cosigning a loan – sometimes ones that aren’t immediately evident – so you’re going to want to consider every factor possible before taking this plunge.
In this article, we’re going to go over what it actually means to cosign a loan, what your responsibilities are, and some tips to help the process if you do decide to cosign a loan.
What Does “Cosigning a Loan” Actually Mean?
In essence, cosigning a loan means that you’ll help to complete the application for that loan along with the primary person applying for it, and you’ll be agreeing to share the responsibility of ensuring the loan is paid off. This doesn’t mean that you’ll necessarily need to make any payments yourself, but it does mean that if payments aren’t met for whatever reason, you’ll share in the repercussions.
But you still might be asking yourself, “why should I cosign a loan?” Well, one of the main reasons would be to help a friend or family member in need. Due to various reasons – poor or shallow credit history, insubstantial income, recent job loss, etc. – some people may have a hard time qualifying for a loan. When someone who isn’t lacking in these areas agrees to cosign a loan with them, they may have a better chance of getting approved for that loan. And the more important the loan is to that person, the bigger the impact you can make in their lives by helping them to get approved.
What are Your Responsibilities When You’re Cosigning a Loan?
Helping someone get approved for a loan is all well and good, but it’s essential to understand the risks you’re taking before you agree to anything like this. After all, the reason a lender may need a cosigner to get involved is because the primary borrower hasn’t proved that they generally have been able to borrow responsibly in the past. So if they’re not confident in this, this may give you a reason to be a little wary as well. Let’s dive into some of your responsibilities as a cosigner and the potential risks you’ll be taking on.
1. You May Need to Make Loan Payments
If you’ve cosigned a loan and your friend or family member can’t make a payment, it may fall to you to step in and take on the burden. And if a payment does end up being missed, you can likely expect to see late fees tacked on to the scheduled payments that you’re now on the hook for. Whether or not your friend has a good reason to miss their payments is irrelevant to the lender; they’re going to do what they can to get their money, and that may put their sights directly on you. This could mean that they’ll start to reach out to you, you could start hearing from debt collectors, and you could even have legal action taken against you.
2. The Loan Will Become a Part of Your Credit History
If your friend does start to miss payments, not only will you be on the hook for them, your credit history will also feel the full weight of these missed payments. The lender will likely start to report these missing payments to credit bureaus, and this can start to damage your credit score. What does this mean for you? Well with a lower credit score, you may have a harder time getting approved for a loan, and if you do get approved, these loans may come with higher interest rates than they would have if your credit score had remained strong.
3. The Loan May End up Being Your Responsibility
Generally speaking, if you’re cosigning a loan and this goes awry, there’s no easy out for you. You’ll be tied to the responsibility and outcomes of that loan unless it’s refinanced or consolidated, you manage to get a cosigner release, or if you can sell the asset and pay off the loan using that money. But these things aren’t necessarily easy outs.
4. The Loan May Affect Your Ability to Borrow Money
Like we mentioned earlier, you may have a hard time getting approved for a loan in the future if significant damage has been done to your credit history because of a loan you’ve cosigned. But how does this work exactly?
Well, when you take on more debt, your debt-to-income ratio (DTI) goes up. This is a figure that shows how much debt you have compared to how much income you’re bringing in. When a lender is evaluating you as a borrower, they want to know that you’re able to handle your debt effectively. In order to make this call, they may look at your DTI to get more insights into you as a borrower. If this number is too high for their liking, they may decide not to lend you money.
When Should You Consider Cosigning a Loan?
While cosigning a loan can be a risky venture, there’s a reason it exists in the first place. If you’ve gone over the potential risks and decide you want to take your chances, here are some things you may want to consider.
1. You Can Handle the Potential Risks
Like we’ve said, if you feel like you can handle the risks involved, it might be feasible to cosign a loan. Being well-equipped in this scenario might mean you have a substantial amount of extra cash on hand to handle any potential payments, or you may have assets in your name that could help you handle a loan if your friend or family member ends up defaulting on their payments.
Either way, you should still make sure that you’ll have the necessary capital to qualify for any loans you may want to apply for down the line. You may need your money and assets for that, after all.
2. You’ll Benefit from the Loan
Another instance in which it might make sense to cosign a loan would be if you’re actually getting something out of the equation. For example, let’s say you’re cosigning an auto loan to help someone purchase a car. If you’re cosigning a loan with your partner or you’ll end up with access to the car, it might make sense to help give their application an extra bump in the right direction.
3. The Other Person is Out of Options
Finally, whether you’re getting something out of it or not, you may just want to give a loved one a hand. Still, you’ll need to make sure you’re aware of all the risks involved and that you’re in a position to handle them. But assuming you’re amply prepared if things go south, it’s okay to help someone you care about.
What to do if You do Cosign a Loan
If you do end up taking the plunge and cosign a loan, make sure you do your best to manage the risk appropriately. Here are some things you can do that may help you stay on top of this process and hopefully avoid any serious negative impact.
1. Open Lines of Communication
When you cosign a loan, you’re going to want to do your best to stay in close contact with the primary borrower. If they anticipate missing a payment, you’re going to want to know about it as far in advance as possible so you can step in and avoid any of the negative consequences of a missed payment. While it’s not ideal to have to make these payments yourself, this is the agreement you made when you cosigned the loan. If you maintain communication with them, hopefully you can get some insights into why they’re missing payments and help to regulate the situation.
2. Stay Informed
On top of keeping in contact with the primary borrower, you’re going to want to make sure you have direct access to the necessary loan and payment information. Make sure that if any late payments are made, the lender will be informing you as soon as possible. In general, keep up to date on all relevant information as it pertains to the loan you’ve cosigned.
3. Don’t Take on More Risk Than you can Handle
If you’re cosigning a loan, it may be a good idea to avoid attaching your name to a large or a long-term loan, particularly if the purpose of this loan is to give the primary borrower an opportunity to improve their credit history. If you ensure that the loan is relatively easy for you to pay off, you’ll at least reduce some of the potential risk. And the shorter the term, the less amount of time you’ll have to spend keeping track of it.
Be Thoughtful and Responsible
In the end, the decision to cosign a loan or not is up to you. Just remember that if it’s something you’re considering, evaluate all the potential risk, maintenance, and effort on your part that it’ll take over the course of the loan.
We get that it can be tough to say no to someone important in your life during their time of need, just make sure you don’t bite off more than you can chew. Because at the end of the day, if you’re going to have too hard of a time handling the loan if they can’t manage it, you may not be helping as much as you think.