Know the risks before you cosign a loan. There are many reasons you may be asked by a friend or loved one to cosign a loan for them - perhaps they are unable to get approved without a cosigner or getting a cosigner will enable them to get a lower interest rate on a loan. Whatever the reason, you should know what the risks are because cosigning a loan can have serious consequences for you.
1. Cosigners Are Responsible To Repay The Loan If The Borrower Defaults
A common misconception about cosigning a loan is that it is only to get the loan approved and it doesn’t stick with you after that point. Unfortunately, that is completely false. According to Experian, cosigning a loan for someone means you are contractually obligated to repay the loan if the other borrower fails to pay. In fact, you are equally responsible for the debt. This means you should be prepared to make the monthly payments on the loan if necessary. Moreover, if the loan is defaulted on you could even be sued by the lender for the remaining balance.
A survey by creditcards.com discovered that 38% of adults who cosigned a loan or credit card ended up having to pay for some or all of the loan. Clearly there is significant risk involved in cosigning a loan, so you should take time to think about the situation before jumping in.
2. Some Loans Have A Cosigner Release Policy
A cosigner release policy stipulates conditions that must be met in order to release a cosigner from the loan. This is not available for all loans as it depends on the lender and type of loan. In general, lenders do not notify borrowers when they are eligible for a cosigner release - it is something that borrowers must inquire about. If you agree to cosign a loan with the idea that you will be released from your obligations after a certain amount of time, you may be disappointed. Take private student loans for example. The Consumer Financial Protection Bureau found that 90% of private student loan borrowers who applied for a cosigner release were rejected. The most definitive way to be released from your obligations as a cosigner is for the other borrower to refinance the loan solely under their name.
3. Cosigners Can Request Copies of Statements From The Lender
If you decide to cosign a loan, you can and should request copies of the monthly statements from the lender. This way you can monitor the payments and verify that there are no missed payments. You can also get credit monitoring alerts from a free service, like Credit Karma, however you will only be notified of a missed payment after it is reported to credit bureaus. You should also make it a habit of checking your credit reports on an annual basis. To learn more, read our article How Can I Get My Free Annual Credit Reports.
Before you agree to cosign a loan, you should make sure the other borrower sets up automatic payments for the loan and that they can actually afford the monthly payments.
4. Missed Payments Will Hurt A Cosigner’s Credit
Because cosigners of a loan are equally responsible for the loan, it will be on your credit reports. Also, the biggest contributor to your FICO credit score is payment history. So it’s no surprise that a missed payment on a loan you cosigned can lower your credit score. Late payments stay on your credit reports for up to 7 years, but the negative impact of a delinquent account on your credit score fades over time. On the flip side, if all of the payments of the loan are made on time your credit will actually improve.
5. Cosigning A Loan Could Prevent You From Getting Approved For A New Line of Credit
When a lender is evaluating your creditworthiness, one factor that is commonly used is your debt-to-income ratio. Debt-to-income ratio, or DTI ratio, is calculated by dividing your total monthly debts by your monthly pre-tax income.
The monthly payment for a cosigned loan will be included in the calculation even if you never have to pay it. Thus, cosigning a loan can actually prevent you from getting approved for a new line of credit. Your debt-to-income ratio is most commonly used by mortgage lenders to determine how much house you can afford, but other lenders use it as well.
As you can see, cosigning a loan is a serious commitment that can have lasting financial effects (as well as effects on your relationship with the other borrower). Make sure that you can trust the person who is asking you to cosign a loan with them. Don’t hesitate to talk to them about if they can really afford the monthly payments. Remember that if for whatever reason they stop making the payments, you will be responsible.
Learn about other common credit misconceptions in our article, Top 10 Credit Myths Debunked.