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 trusted friend, a 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. Here are some examples of when using a co-signer would make sense:
- You have poor credit: If you have a credit score less than 580, your score is considered poor, and it may be harder to get approved for a loan. The lower your credit score, the more risky you’re deemed as a borrower.
- You don’t meet the minimum income requirements: Some qualification requirements include a minimum income. If you don’t meet the minimum at the time of application, or you have another income in the works, a co-signer can help bridge that gap.
- You’re self-employed: If you’re self-employed and don’t have a stable, predictable income, it can be difficult to get approved, even if the monthly payments are well within your budget.
- You’re a young adult and don’t have a steady income or a solid credit history: Not having a financial or credit history can really hinder your approval odds. Having a co-signer with an established financial history can help you qualify.
- You have a high debt-to-income ratio: Your debt-to-income ratio is the amount of debt you owe versus your income. If you have large amounts of debt at the time of application, you may want to start thinking about a co-signer.
“Co-signing or co-borrowing a loan is really only something you should do if you’re prepared to pay back the debt,” says Lauren Anastasio, CFP at SoFi. “Being a co-signer or co-borrower for a loved one or business partner can lower their cost of borrowing or even help them obtain a loan they wouldn’t otherwise qualify for, but that only happens because the lender will hold you responsible for the debt if anything goes wrong.”
How does co-signing a loan affect your credit?
Co-signing a loan means adopting some of the responsibility of a loan that isn’t yours. “Being a co-borrower on a personal loan will have the same impact on your credit score as if you were taking the loan out yourself,” says Anastasio.
If the primary borrower doesn’t pay the loan, the missed payments could negatively impact the co-borrower’s credit score, says Leslie Tayne, founder and head attorney at Tayne Law Group. “The debt can also impact your credit utilization, which can affect your credit score.”
That said, there are some positive impacts to consider as well. “The loan can help diversify the kinds of accounts you have, which can help your credit score,” says Tayne.
Before you make the decision, conduct an audit of your financial health, history and credit to weigh the downsides and advantages that could come with co-signing. If you don’t think a potential drop in credit or a possible payment is something that you could financially handle, it may be a good decision to reconsider co-signing a loan.
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 primary borrower 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.
Is co-signing different depending on the type of loan?
The process of co-signing may look different from lender to lender, but the responsibility of a co-signer, regardless of the loan type, will typically remain the same: to make the payments if the primary borrower fails to do so.
Co-signer release, on the other hand, can look slightly different based on the type of the loan. For example, some mortgage loans require the primary borrower to refinance in order to release a co-signer from the loan, while others, like student loans, have set rules for when the primary borrower may take full responsibility for the loan.
How to protect yourself when co-signing a loan
The first way to protect yourself as a co-signer is to make sure you’re fully aware of what you’re signing up for. Hold an “interview” with the primary borrower and ask them about their income and how they plan on making the monthly payments.
This also involves thoroughly reviewing the loan and its terms so you know exactly what you’re liable for if the primary borrower is unable to make the payments on time. The best way to initially protect yourself is to be informed.
After you know what the loan terms are, establish a plan with the primary borrower that involves a monthly check-in when the payments are due. This not only will create a level of accountability, but also will keep you in the loop as to what you may be responsible for paying.
Lastly, before signing, establish a timeline that will allow the borrower to raise their credit score or gain some financial history without leaving you potentially responsible for payments for a prolonged period of time.
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.