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Co-signing a loan can saddle you with some surprising — and unpleasant — consequences.
When a friend or family member asks you to co-sign a loan, it doesn’t seem like a big deal. You’re just helping out a loved one, right?
But co-signing a loan comes with serious, often hidden risks to your finances and your relationships. Here are some things to consider before you agree to lend a hand.
How does co-signing a loan work?
Your best friend, Bob, is in the market for a loan — a personal loan, car loan, student loan or even a mortgage. Unfortunately, Bob’s having trouble qualifying for a good interest rate or maybe even getting approved. He doesn’t have great credit scores or meet other application criteria, so lenders view Bob as a risky prospect. But, wanting to get approved nonetheless, Bob asks you to co-sign a loan for him.
If you’ve got good credit, adding your name as co-signer alongside Bob’s suddenly makes his application much more attractive to lenders. Now, Bob qualifies for a great loan and happily skips off into the sunset with the money.
But what does co-signing a loan actually mean for you?
When you act as a co-signer, you help another person qualify for a loan that they wouldn’t otherwise be able to get. Obviously, that’s a huge benefit to the other party.
But it also means you have to put your own finances on the line. As a co-signer, you’re not just someone with good credit offering a character reference to a friend with bad credit (or no credit). You’re actually committing to be 100% responsible for that debt if your buddy doesn’t pay.
What are the financial consequences of co-signing a loan?
If you think your role is over after signing on the dotted line, think again. Not only did you just do your friend a favor — you signed up for a brand-new loan with your name on it.
In the spirit of friendship, you’ve taken on a significant financial risk and responsibility while your pal gets to enjoy the benefit — a new car, a paid-for education or maybe a wad of hundred-dollar bills. What do you get as a co-signer?
- You’re responsible for paying the loan. Surprise! If your friend misses a payment, that’s not just bad on him. It’s your responsibility to cover it out of your pocket … or suffer the consequences.
- The loan appears on your credit reports. You’ll see the new debt on your reports, along with any black marks associated with it — late payments, defaults and missed payments sent to collections.
- It can impact your ability to get a loan for yourself. Taking on any kind of additional debt typically increases your debt-to-income ratio. This doesn’t directly affect your credit scores — however, debt-to-income ratio is a key factor for lenders in evaluating whether to give you credit, and, if so, for what terms.
- Your credit could take a nosedive. If your friend stops paying on the loan and you don’t pick up the slack, the lender will start reporting the missed payments or loan default to the credit bureaus. And that kind of data on your credit reports can tank your once-beautiful scores.
- You’re legally on the line. Since you’re just as legally responsible for the debt as your buddy, the lender may choose to sue you if the loan goes unpaid. Then a court could easily order you to pay 100% of the debt plus legal fees. And recouping any of that cash might mean you’re forced to turn around and sue your friend.
- You’re stuck with the loan. In general, you can’t jump ship on a co-signed loan when things go south. Getting your name off a loan that you’ve committed to pay isn’t a matter of simply erasing your signature. You’re chained to that debt unless your friend qualifies for a refinance or assumes the loan without you as a co-signer, or closes the loan.
What else could go wrong?
Co-signing a loan is a financial minefield. But equally important — if not more important — is the damage that co-signing can do to a relationship.
Even under the best circumstances, when your friend makes every payment on time as promised, the nature of your relationship is fundamentally changed by co-signing. Instead of being equals, your buddy is now indebted to you … and no one likes that feeling. Plus you might feel like you have to keep an eye on your pal’s financial activities to make sure the debt gets paid.
Still worse is what happens when the person you’ve helped fails to make a payment. Suppose your good friend splurges beyond their means on a vacation while you’re forced to cover a monthly payment. It would be natural to feel mounting resentment. Even if he’s having financial troubles that aren’t his fault, you might hate the fact that his money problem has now become your money problem.
So what should you do?
In general, co-signing a loan is risky on both a financial and a personal level. But saying no to a loved one in need can feel downright mean. After all, you want to help your daughter qualify for a college loan or help your best friend get a car that will get him to and from work.
If you ultimately resolve not to co-sign, share your decision from a place of love and respect. Educate your loved one on the responsibilities you’d be taking on by co-signing a loan — many people don’t realize the extent of risk they’re asking you to assume with your own finances. And be prepared for the other person to express disappointment. If possible, approach the conversation with some alternatives to co-signing — a website with info on college grants or easy-approval loan options.
If you do decide to co-sign, there are some things you can do to try to protect your own finances, and your relationship, as much as possible. Here are a few.
- Get online account access so that you can view statements without nagging your friend.
- Have the lender notify you immediately if payments are overdue.
- Plan for the worst by setting aside money to cover any missed loan payments.
- Don’t co-sign for someone who you know is irresponsible with money or for a person you’ve only recently met.
- Communicate regularly with the other person about the status of the loan.
Finally, if you co-sign, consider thinking about the loan as a monetary gift. Then, getting repaid is a bonus — not a requirement. And you’ll spare your relationship the pressure of money woes.