There are a number of instances where you might be asked to co-sign a loan. For example, your son or daughter may come to you and ask if you can co-sign a loan with them to get a new car.
Perhaps they just graduated from college and have no credit history of their own. But they need a set of wheels to get to work and have been turned down for a loan because of the lack of credit history. You really want to help them out, and you know your credit is strong enough to get them approved.
Before you sign on the dotted line, make sure you know how this step can affect your own credit score. If you’re trying to maintain excellent credit, you may be cautious about everything you do, especially if it involves a credit check.
When you co-sign for a loan, you will go through the same process as the primary borrower, so it pays to understand what it really means to be a co-signer.
When is a co-signer necessary?
A person needs a co-signer if they don’t have an established credit history of their own like in the above example. Young adults may find it hard to qualify for a car loan or even a credit card unless they have a co-signer.
People with a bad credit history can also benefit from a co-signer. They may be trying to rebuild their credit, but often difficult to find a lender who will give them a chance.
Many times, the only way they can secure credit is by having a co-signer. For them to get back on their feet, they need someone with a good record to vouch for them and be willing to put their name on the loan or credit card.
Who qualifies as a co-signer?
To qualify as a co-signer, you must have an established credit history, including a good credit score that meets the requirements of the lender. You’ll also need to have a job or stable income while meeting all the same guidelines as the primary borrower.
Some lenders only consider a co-signer who is a family member. Others accept friends or anyone else who is willing to become a co-applicant. As a co-signer, you’ll have to go through the same application process as if it were your own loan.
They’ll also verify any information provided on the application, including references and employment. When a credit check is run, you’ll have an inquiry show up on your credit report, the first way being a co-signer will impact your credit rating.
While this process only dings your credit slightly, it can be seen by other lenders for two years.
It’s also important to realize that even as a co-signer, you don’t need perfect credit. You may have had financial issues in the past or missed a few payments over time.
When you’re a co-signer, you must meet the same application criteria, but you don’t need to exceed the requirements set for the primary borrower.
For instance, a creditor may accept fair or even poor credit as long as all negative information is at least one year old. While the primary borrower may fit this requirement, they may not show enough income or have held a job long enough to qualify.
If you’re the co-signer, you could meet the requirement for income and have only fair or poor credit for the loan to be approved.
What happens after being approved as a co-signer?
If you are approved as a co-signer and the primary applicant receives the loan, you’ll generally need to sign the same paperwork, binding you to the same terms as the borrower.
After that, you may not receive any information about the loan or payments because this paperwork typically goes directly to the main applicant. In fact, you may never hear anything about the loan as long as all goes well and full payments are received on time.
However, the loan still impacts you because the account is added to your credit report, assuming the lender reports to one or more of the three credit reporting agencies. The loan is listed as an account with the same information as would show for the borrower.
It provides the balance amount, date of last payment, and other information that creditors would use to decide whether to approve you for a loan or credit in the future.
Can co-signing a loan help your credit?
Serving as a co-signer can actually help your credit in a few different ways. You may find that your existing credit becomes more diversified, which can improve your credit score.
For example, you may have credit cards but no installment loan. By adding a car loan to your account history, it shows you have different kinds of credit, which could raise your credit scores.
You also get credit for an account that is paid on time, providing a positive effect on your credit because it is one more account in good standing. Over time, you could potentially see your score move from fair to good, or even from good to excellent.
For this reason, sometimes it is good to say yes to being a co-signer. Of course, there are plenty of other considerations to think about, but there definitely are some advantages.
Can co-signing a loan hurt your credit?
Co-signing is a risky venture for many because of the potential negative consequences involved, most of which are out of your control.
They often overshadow any of the positive results, and they cause people to pause when asked about co-signing. There are several ways you could actually damage your credit or your ability to qualify for new credit when you agree to be a co-signer.
Debt-to-income Ratio
Because the new loan is added to your credit report, the monthly payment is figured into your total debt even though you aren’t the one using the money. That’s because, from a lender’s perspective, you’ll be required to repay the debt if the original borrower fails to make the payments.
Every credit account you have with a balance reduces the amount you can borrow. Lenders like to keep the amount of debt compared to income as low as possible.
Typically, around 30% is considered to be the top limit for your debt-to-income ratio. So if you have a monthly income of $3,000, your monthly debt payments should be no more than $900 per month.
If you already pay $650 a month for things like credit card minimums and a few student loans, and a relative adds you as a co-signer for their car loan with a monthly payment of $250, you would technically be maxed out and unlikely able to get more credit of your own.
Failure to Pay
Another issue, and probably the biggest one, is what happens when the borrower is unable or unwilling to make the monthly payments. Every late payment is a strike on your credit – not just theirs.
In fact, you may not even know there is a problem with the account until it is 30 or 60 days past due, which already results in at least one negative credit item. Many times, a co-signer gets a letter or phone call when the creditor cannot connect with the borrower.
If this happens, it may be the first time you’re actually aware that there’s a problem. Unfortunately, your credit is already damaged and you’ve got to decide how to move forward.
You’re left with one of two options. You can either make the overdue payments to prevent further action or you can allow the collection process to continue. Both options have lasting consequences.
Making the Payments
If you take over the payments as a co-signer, you commit to adding this obligation to your budget every month until you pay off the balance. For a credit card, you can close the account so that no additional purchases are added.
However, you’re still obligated to pay off the balance. While this option prevents further damage to your credit, you’re left with an additional bill and no recourse unless the borrower is willing to pay you back.
A closed account can also have a negative impact on your credit scores because it lowers the age of credit history, which is another factor in determining credit scores. If it’s a relatively new account, it might not behave a huge effect, but is still something to consider.
Not Making the Payments
If you choose not to make the payments on the account, the loan will eventually default or the credit card will close and be charged off. In either case, it causes more negative information to be added to your credit reports.
A repossession of a car, for example, can be a serious result because it hinders your ability to get financing for a vehicle of your own in the future. There is no way to designate on a credit report that the car loan wasn’t yours because legally it was your responsibility even if the car was not.
Most negative information stays on your credit report for at least seven years from the date of last payment. This makes it difficult for you, the co-signer, to qualify for any loans or credit of your own.
Remember that you are as responsible for the debt as the primary borrower. Anything that happens on that account, good or bad, impacts your credit.
Is co-signing a loan right for you?
Deciding whether you should be a co-signer comes down to your unique situation. If you can’t afford to make the payments in the event the borrower is unable to, you should not commit to this agreement.
You also need to decide if you trust the other person to be responsible with their finances. Even then, you should be in a position to help out if they run into problems. A job loss, illness, or other disaster situation could render them unable to meet their obligations.
You also have to think about how this arrangement will affect your relationship with the other person. It’s been commonly said not to mix family and business, and co-signing on a loan or credit account is mixing the two. You can cause irreparable damage to your relationship, which may be worth even more than your credit score.
Final Thoughts
Being a co-signer can enable someone to get a start in life and gain the credit history they need to reach their goals. However, it carries a lot of risk that you must be prepared for. If you’re unsure of whether you should agree to be a co-signer, it’s probably an indication to say no.
Regardless, you need to understand what it means to be a co-signer and all the different ways it can impact your life now and in the future. Once the decision is made to be a co-signer, you must live with the results.
Take plenty of time to decide what is best for you and not just for the other person. After all, no one is going to protect your credit but you.
