Ever been asked to be a cosigner for a car? On paper, it sounds like you might be helping someone out. Maybe your spouse needs help with that vehicle purchase or it’s your child’s first car. Unfortunately, there are often more reasons not to cosign than there are exceptions.
What does it mean to be a cosigner?
A cosigner is someone who applies for a loan with another person, and legally agrees to pay off their debt if they aren’t able to make the payments. The most common reason to use a cosigner is if someone is struggling to get approved for a loan based on their credit score, income or existing debt. A cosigner could be a friend, family member or anyone close to you who has a strong credit score and a consistent income.
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 the lending company will lose money. But with a cosigner, the lender will be more likely to give someone a loan because the cosigner can step in and make the payments if the other person cannot. With a cosigner, many lenders are more likely to offer better terms on the loan, like a lower interest rate and lower fees.
The risks of being a cosigner
When you’re a cosigner for a personal loan, there’s a lot on the line. While you might think you’re helping someone, how that person conducts themselves when it comes time to settle up with the lender can reflect negatively on you.
“The reality is, if the lender felt the original debtor could pay back the loan on their own, they wouldn’t need a cosigner,” 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 cosigner you probably shouldn’t be the one willing to cosign.”
Here are 10 reasons why you should think twice before cosigning a loan.
1. Cosigning a loan is high risk, low reward
You might cosign 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. Your credit score benefits only slightly from the monthly payments. And since you qualified as a cosigner because of your good credit, you don’t necessarily need more credit lines.
By cosigning a loan, you take on all the risk if the loan is not repaid but may only see a modest improvement to your credit score.
“I advise people against cosigning on loans as the financial risk does not outweigh the reward,” says Jared Weitz, CEO and founder of United Capital Source, a nationwide small business lender.
2. The lender will sue you first if payments are not made
While it might seem strange that the lender would look to you, think about it for a moment from their perspective. It’s true that you may not have borrowed the money, but by cosigning a loan, you enable the person who defaulted to get the loan in the first place. Whether you’re a cosigner for a car or a mortgage, it takes two to tango and the lender can try to sue you if payments are not made.
3. The person you help will be happy, but you will have a lot to lose
Your signature might make the other person happy because you helped him or her out. But that excitement does not last forever. “Buyer’s remorse” can set in.
Even worse, the person who you helped may have bad credit. So they may not be as concerned about whether another negative mark appears on their credit report. Needless to say, you have much more to lose.
“As a bankruptcy attorney, I have seen people driven to file for bankruptcy due to cosigning on a loan,” Duncan says. “They are always well-intentioned but far too often turn out poorly. I’ve also had clients who have filed for bankruptcy and it has left someone who cosigned on a loan with them responsible for the entirety of the debt.”
4. Cosigning a loan can destroy friendships and families
Not surprising when you think about all the time and energy you could spend ensuring the other party keeps up with their payments. This due diligence can take its toll on a friendship and, as the cosigner, your desire not to suffer any negative impacts could be construed as mistrust. And, if they fail to make any payments, that can have a profound impact on your finances and further fuel the fires.
Remember, one missed or late payment could mean a black mark on your credit. You may not be very willing to forgive or forget, and that can definitely destroy a friendship or strain family ties.
5. You are 100% liable on a loan that could be a significant amount
Cosigning 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,” Weitz says. “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.”
Weitz adds that being responsible for cosigned loan payments can derail plans of buying a home or budgeting for children. He recommends keeping the monthly cosigned loan payments in mind when it comes to budgeting, even if the person using the loan is currently making payments.
6. You could face tax consequences from cosigning a loan if the debt is settled
The lender might not want to go through the trouble of suing you and instead 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.
Also, 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 score suffers because of that new mark.
7. Cosigning could make approval of a loan you might need impossible
Before cosigning a loan, think ahead. You might just need a loan yourself one day. For example, consider a cosigner for a car. The cosigner in this situation is actually signing for his wife who has less-than-stellar credit. Unfortunately, by doing this, he has found himself denied for an application on a loan of his own because he “has too much credit in his name.”
“By cosigning a loan you run the risk of increased debt-to-income ratio and also a ding to your credit score if things go sour with the borrower’s payment habits,” Weitz says. “This can prohibit you in the short-, or long-term, from qualifying for loans of your own.”
When you’re thinking about cosigning a loan bear in mind that helping someone out might hinder your own opportunities.
8. You’ll be making that payment if your cosigner defaults
Be prepared to make the loan payment. You may want to consider taking the monthly payment and putting in into a savings account to hold it there. Once you have 12 monthly payments saved, you can stop saving. Hopefully, you never have to pay more than 12 payments on the loan, but be prepared for the worst-case scenario that you have to make the payment.
9. You may need to sue the other responsible party if payments are not made and you get sued
No one likes the idea of suing their friends and family, which is another reason why cosigning a loan can be a bad idea. However, sometimes the situation can arise and if you’re being sued because of a cosigner’s failure to pay, you may need to bring the responsible party into the lawsuit. In some cases, it may be the only way to get them to help with the monthly payment.
This can get very messy, as you can imagine. Not only are relationships tested but, in the eyes of the law, you are just as responsible for your cosigner’s behavior as they are. As the cosigner for a car, boat, etc. you could be sued and, if that happens, you might be left with the unhappy duty of suing the party responsible.
If you are not able to bring the other party into the lawsuit, you can sue them later on to contribute to your monthly payment. Unfortunately, getting a judgment against the other party is much easier than getting him or her to pay. Sometimes, you may need to hire a debt collection attorney or law firm to assist you.
10. You have to be organized enough to keep track of the payments when cosigning a loan
Think it’s hard enough to keep track of all your bills and payments? Well, if you cosign, you’ll also need to keep track of someone else’s bills and payments. This will mean checking each month either online or by calling customer service to make sure the payment has been made. You don’t want to just blindly believe all payments will be made.
Don’t wait until some collector calls you saying payments have not been made in six months. By then, your credit will already have been negatively impacted.
“As a cosigner, do not blindly walk away and put faith in the borrower to make on-time payments,” Weitz says. “Set up a calendar reminder or automatic update online to notify you of payment dates and the status of the loan. 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.”
When does cosigning make sense?
Cosigning a loan can be risky, but it can also be beneficial if done correctly. Using a cosigner makes sense (and is very common) for close family members in certain situations. Parents often cosign their children’s student loans when they’re in college. A couple who purchases a new home might put their spouse down as their cosigner, because both people are equally responsible for the investment.
Cosigning also makes sense if someone is getting back on their feet. Someone who previously lost their job but needs a car to travel to interviews might use a cosigner to take out an auto loan. Presumably, that person will eventually have a job that allows them to comfortably afford their monthly payments.
In any situation, cosigners 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.
Alternatives to cosigning
If you’re unable to find a willing cosigner, or want to avoid the risks associated with cosigning, there are several alternatives that can help you get the money you need:
- Increase your down payment: If you need financial back up but don’t have access to a cosigner, think about increasing the down payment on your loan in order to decrease your monthly payment. You’ll be paying more upfront, but you’ll take less of a hit each month.
- 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.
The bottom line
Cosigning a loan can seem like you’re helping out a friend who doesn’t quite have the credit rating you do. And, in some cases, it’s perfectly reasonable to cosign. Just make sure you consider all the risks and only cosign for somebody you trust. Be sure and have clear lines of communication.
Don’t let dialogue break down or you could find yourself staring down a black mark on your credit and an indelible blot on your relationship.
— Brian Robson also contributed to this story.