On paper, getting a co-signer on a loan seems like a no-brainer: You may benefit from better rates, and both you and your co-signer could see a credit boost if you make on-time payments. However, there are downsides that you and your potential co-signer should understand before you sign on the dotted line.
What is a co-signer?
A co-signer is someone who applies for a loan with another person and legally agrees to pay off their debt if the primary borrower isn’t able to make the payments. A co-signer could be a friend, family member or anyone close to you who has a strong credit score and a consistent income.
Co-signers are common in cases when the borrower is struggling to get approved for a loan based on their credit score, income or existing debt. Lenders perceive applicants with poor financial history as high risk — there’s a chance they won’t be able to repay the loan, which means that the lending company will lose money. A co-signer with good credit improves the primary borrower’s overall creditworthiness, meaning lenders are more likely to approve the loan or offer better rates.
How do you use a co-signer for a loan?
If you’re in a situation where you might need a co-signer, you’ll first want to find the right co-signer. In theory, anyone can be a co-signer for a loan. In practice, however, it’s likely going to be a family member or a close friend.
To use a co-signer, you’ll tell the lender that you plan on having someone else co-sign the loan. The lender will then ask for the co-signer’s financial information and details and adjust the terms of the loan accordingly. The co-signer will also have to be present at the closing of the loan in order to officially sign alongside the primary applicant.
When does co-signing make sense?
Co-signing a loan can be risky, but it can also be beneficial if done correctly. It’s particularly common for young adults to use co-signers, since they often have unpredictable income, a low credit score and little to no credit history. Because of this, it can be difficult or impossible for them to get a loan without a co-signer. As such, parents often co-sign their children’s student loans when they’re in college.
Co-signing also makes sense for someone trying to get back on their feet. Someone who previously lost their job but needs a car to travel to interviews might use a co-signer to take out a personal loan. Presumably, that person will eventually have a job that allows them to comfortably afford their monthly payments.
In any situation, co-signers are there in the event of an emergency. They’re not expected to pay a cent when they sign their name on the loan application, but they are willing and able to use their own money to pay down the loan if the debtor is unable to.
The risks of being a co-signer
If you’re thinking about co-signing a personal loan, there’s a lot on the line. “The reality is, if the lender felt the original debtor could pay back the loan on their own, they wouldn’t need a co-signer,” says Damon Duncan, a bankruptcy attorney in North Carolina. “Finance companies have decades of collective data and information that helps them determine the likelihood someone will pay back a loan on their own. If they aren’t willing to give the person a loan without a co-signer you probably shouldn’t be the one willing to co-sign.”
Here are six reasons why you should think twice before co-signing a loan.
1. You are liable for the full loan amount
Co-signing a loan makes you liable to pay for the entire balance should the guilty party fail to pay. And, unfortunately, most lenders are not interested in having you pay half of the loan. This means that you’ll have to work it out with the other party or get stuck paying off the entire balance.
“Think not only about the amount the loan is for but also the duration,” says Jared Weitz, CEO and founder of United Capital Source, a nationwide small-business lender. “Once you sign a loan, it’s not for a few months, it’s for the entire duration of the existence of the loan — sometimes this is years.”
2. Co-signing a loan comes with a high risk and a low reward
You might co-sign on a loan for a car you’re not driving or a mortgage for a house you don’t live in, but that doesn’t change your liability if the primary borrower fails to make payments. Your credit score benefits only slightly from the monthly payments. And since you qualified as a co-signer because of your good credit, you don’t necessarily need more credit lines.
3. You have to be organized enough to keep track of the payments
If you co-sign a loan, you’ll want to keep tabs on monthly payments, even if you trust the person you co-signed for. If you wait to get a call from a bill collector informing you of missed payments, your credit will already have been negatively impacted.
“Set up a calendar reminder or automatic update online to notify you of payment dates and the status of the loan,” says Weitz. “If needed, set up a monthly check-in with the borrower yourself to make sure there are no red flags approaching that may lead them to no longer be able to make payments.”
4. The lender will sue you first if payments are not made
If the primary applicant defaults on their personal loan, the lender will come after you first. After all, the primary applicant likely does not have stellar income or many assets. If they did, they wouldn’t have needed a co-signer in the first place.
In addition to the financial strain this places on you, this type of situation could also place a significant strain on your relationship with the person you have co-signed for. Constantly ensuring that the other party has made payments can take a toll on friendship, and, as the co-signer, your desire to not suffer any negative impacts could be construed as mistrust.
5. If the debt is settled, you could face tax consequences
If the lender doesn’t want to go through the trouble of suing you, it may agree to settle the balance owed. That will mean you could have tax liability for the difference. For example, if you owe $10,000 and settle for $4,000, you may have to report the other $6,000 as “debt forgiveness income” on your tax returns.
And settling on the account will leave a negative mark on your credit report. The account does not state “paid as agreed,” but rather “settled.” Your credit score suffers because of that new mark.
6. Co-signing could make approval of your own loan impossible
Before co-signing a loan, think ahead to future loans that you might need. Even though a loan you co-sign is not in your name, it shows up on your credit report, since it’s debt that you are legally obligated to pay. So when you go to apply for another loan in your own name, you might find yourself denied for an application because of how much credit you have in your name.
Alternatives to co-signing
If you’re unable to find a willing co-signer, or if you want to avoid the risks associated with co-signing, there are several alternatives that can help you get the money you need:
- Build your credit: The main reason why applicants struggle to get approved for loans is because they have a poor credit score. Put your application on hold and work on getting your credit score to a place where lenders will be willing to give you a loan. You can build your credit by paying bills on time, paying your credit card balances in full or paying more than the minimum monthly payment.
- Offer collateral: Some lenders will accept collateral in exchange for your loan. If you’re comfortable with the risk, think about putting down your home or vehicle as collateral. Remember that if you can’t pay off your loan, you will lose your collateral, which can put you in serious financial trouble.
- Search for bad-credit lenders: Lenders that specialize in personal loans for bad credit may be the best place to turn if you’re having trouble qualifying elsewhere. You may encounter double-digit APRs, but these lenders are more trustworthy options than payday lenders.
The bottom line
If you’re having trouble qualifying for a loan on your own, enlisting a co-signer could be a viable option. However, before accepting the loan offer, sit down with your co-signer to have an honest discussion about the loan amount, terms and repayment plan. If you have contingencies in place, it’s less likely that your relationship will be at risk down the line.
Featured image by Bruce Ayres of Getty Images.