5 Pitfalls of Cosigning a Loan
Most of us want to help our friends and family. One of the ways we can do this is cosigning on a loan. At first blush, cosigning looks like the perfect solution. You aren’t actually providing a handout; you’re helping your friend or relative get back on track.
Unfortunately, it’s not that simple. Cosigning a loan is a real commitment, and it can result in difficult consequences for your financial situation:
1. You are Ultimately Responsible for the Loan
A borrower only needs a cosigner when he or she is unable to qualify for credit without help. When you cosign the loan, you are accepting responsibility for the repayment. If the primary borrower doesn’t pay, their creditor can come after you.
2. Their Loan Appears on Your Credit Reports
Because you are ultimately responsible for the loan, your ability to qualify for credit can be impacted. The debt you cosign for figures into calculations made by future lenders. If you plan to apply for a car loan, or a mortgage, anytime soon, you might find that cosigning on a loan prevents you from receiving the best terms – or even qualifying at all. And because the co-signed loan is considered your debt, it increases your debt to income ratio, further making it difficult for you to qualify for new accounts.
As long as the borrower makes payments on the loan, chances are that your credit score won’t be impacted too greatly, even if your ability to borrow on your own is reduced. However, this changes if the borrower begins missing payments. Since your name is on the loan, too, your credit can also be damaged. This not only affects both your ability to borrow and the rates you are offered, but it can also mean higher home and auto insurance premiums.
On top of that, the cost of the loan can rise. When the borrower misses a payment, some lenders will demand immediate payment, in full, but others might let the penalties and late fees add up. Once the borrower finally defaults, you will be left to pay for the original loan and all of the new fees.
3. The Lender Has No Obligation To You
A cosigner doesn’t have the same protections that borrowers do. Normally, borrowers are given some warning before the collection notices start. However, the relationship of a lender to a cosigner is very different, often a cosigner is at the mercy of a lender. On top of that, a lender can go straight to the cosigner without first trying to collect from the borrower.
Some states offer a few protections to cosigners, such as the requirement that lenders allow the cosigner a certain amount of time (for instance 30 or 60 days) to work out a payment plan or to pay the debt in full.
4. Removing Yourself from a Loan is Hard to Do
It’s practically impossible to remove yourself from a loan that you have cosigned. In most cases, the lender won’t remove your name because it makes better sense for them to be able to hold two people responsible for the loan. Unless the debt is paid off in full, the borrower would have to choose to either refinance the loan in his or her own name, or refinance with a new cosigner in order for you to be released from the obligation.
5. Your Personal Relationship Can Become Strained
Countless relationships have been ruined over money. If the borrower defaults and you are left picking up the pieces, it can be a real strain on your relationship. You may feel resentment because you are the one paying for someone else’s mistakes, and the borrower might even feel resentment or embarrassment over the situation.
For the benefit of both your finances and your relationship, you should consider how much you trust the borrower and under what circumstances they are asking you to cosign. My parents cosigned on my first car loan because they knew that I was responsible, and that I would make all of my payments on time. I had a steady job, and lived within my means.
It’s one thing to cosign for someone just starting out, who needs a little help establishing a financial reputation, and quite another to cosign for someone who has already demonstrated dubious money management habits. Remember: Lenders know what they are doing. If the lender won’t approve someone, there is probably a very good reason. Carefully consider your options before cosigning, and think about helping in an alternative way.
Image: Vaselena / iStock.