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Co-signing a loan: Risks and Benefits

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Co-signing a loan: Benefits and Risks

Co-signing the loan may help the borrower qualify however it can impact your credit score as well as your overall financial situation.

The last update was on Dec 16, 2022

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You may be required to co-sign a loan by your parent, spouse or acquaintance, particularly if your credit score is higher than theirs.

However, what may sound like a noble act helping someone to find money for a brand new house or tuition for college could have consequences that you didn’t expect.

What is co-signer?

A co-signer is someone who adds their name, credit score and financial details to the primary applicant’s loan application, agreeing to be legally accountable to the loan amount, and any additional charges, in the event that the borrower is unable to pay.

A majority of people need or want co-signers because they don’t be eligible for the loan all by themselves. If you have a strong financial profile, co-signing for someone with a lower credit score or weak credit score can boost the odds of obtaining a loan or obtaining an interest rate that is lower.

Unlike a in which two borrowers have equal access to the loan, in a co-signed loan co-signer is granted no claim to the loan even though they may be on the hook for repayment.

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Risks of co-signing a loan

Co-signing on a loan put you into a uniquely risky situation. These are the potential risks to consider as well as ways you can safeguard your finances as well as your relationship should you decide to co-sign.

1. You are accountable for the entire loan amount

The biggest risk co-signing a loan isn’t just about lending your credit rating to aid someone else. It’s a commitment to pay the debt when they’re unable to do so, including any collections or late fees.

Before signing a co-signing agreement, review your personal finances to make sure that you are able to cover the loan payment in the event that the primary borrower cannot.

2. Your credit is at risk

If you sign a co-signing loan and pay it back, both the loan and the payment history will show up on your credit reports as well as the credit report of the borrower.

In the short run you’ll experience a brief hit to your score on credit, according to Bruce McClary, spokesperson for the National Foundation for Credit Counseling. The lender’s hard pull of your credit prior to approving the loan can affect your credit score, he says, and so could the increase in your overall debt load.

The most important thing to remember is: Any missed payment by the borrower can negatively affect the credit rating of your. Because payment history is a factor, any error in this area can ruin your credit score.

3. Credit access may be affected

The potential risk for co-signing a loan to your loved ones is that you may be rejected for credit when you need it. Potential creditors will take in the co-signed loan to determine your total debt levels and could decide that it’s not risky to extend you more credit.

McClary recommends that you check your credit report on a regular basis following co-signing in order to keep an eye on your finances.

4. You could be sued by the lender.

In certain states, when the lender does not receive payments, it may try collecting money from the co-signer prior to going after the principal borrower, as per to Federal Trade Commission.

In order to reach that point, the borrower would likely have fallen behind on several payments, and the debt would already be affecting your credit. Lenders are likely to consider legal action when you are 90 or 180 days after it was due.

If something happens that is catastrophic and you are sued for nonpayment, you’re responsible as co-signer of all expenses, including attorney’s fees.

5. Your relationship may be damaged

The borrower may start out making full, on-time payments toward the loan or credit card, with good intentions. But financial and personal situations are subject to change.

Children who are in trouble when they make payments on co-signed credit cards or car loan may hide the shortfall away from parents, until situation worsens, ruining trust within the family.

Couples who are going through divorce often have to deal the financial ramifications of a co-signed car or mortgage, according to Urmi Mukherjee who is a certified financial counselor at Apprisen, a non-profit financial counseling firm. In such cases it can be difficult to persuade one spouse to contribute their fair share particularly if the spouse has left the house or renounced the car.

6. Removal of yourself as a co-signer isn’t an easy task.

If there are issues, removing yourself as the co-signer is not always easy.

A lender who allows a co-signer to be let out of the loan may require a credit check of the principal borrower to ensure they’re able to make the repayments by themselves. Student loans or personal loans generally require a specific number of on-time payments before the lender can reassess the borrower in question to determine whether they are able to make the payments independently.

The benefits of co-signing a loan

The benefit of co-signing an loan for someone is obvious — you can help them qualify for student loans, a credit card or some other financial product they could not have on their own or pay less interest by offering a lower rate.

If someone is just beginning to build credit or trying to rebuild their finances, having a co-signer with a high credit score and a good credit history can be a huge advantage.

There aren’t all personal loan lenders accept co-signers, so make sure to check before you apply.

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Can co-signing a loan help build credit?

Co-signing with a co-signer could help increase your credit score in the following ways:

If payments are made on time, they add to your payment history. But, if you’ve got a good score and well-established credit, the effect may be minimal compared to the danger to your score if the borrower doesn’t pay.

You might get a small advantage if your credit score improves. It’s useful to keep as well installment loans (with regular payments) and revolving account (like credit card).

The person who you co-signed with is able to build credit these ways:

It may help them qualify for credit that they would otherwise not qualify for, as well as helping to improve a poor credit score.

The ability to make timely payments on the account can build a good credit history.

How to safeguard your credit score if you co-sign on a loan

Before you co-sign, ask whether the lending institution knows what their rights and responsibilities are and how you’ll be notified in the event of a payment issue.

Also, solicit the primary borrower to grant access to the loan account to allow you to keep track of payments, suggests Byrke Sestok, who is a certified financial planner at the New York-based Rightirement Wealth Partners.

“It’s not an issue with trust — issues do occur,” Sestok says. “If you find out within the first month that somebody has a problem paying back the loanor not paying back the loan], you have the option to do something about it.”

To be prepared for such situations, establish an arrangement between co-signer and borrower upfront and in writing, which defines expectations for each individual, McClary says. A private agreement can help to eliminate mismatching expectations, he says.

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Alternatives to co-signing a loan

If you’re not willing to co-sign on a loan you can choose alternatives for the borrower:

You can try a family loan If the person who is borrowing wanted to have one of their family members co-sign for them, they may decide to go with a different. A family loan does not involve any third-party lenders, which means there’s no formal request or approval procedure, however it must be accompanied by an official, signed arrangement between two of the parties summarizing conditions. Family loans can allow borrowers to get less expensive loans and avoid lenders who are predatory, but they still put another person’s finances at risk should the borrower become unable to repay the loan.

Offer collateral: A borrower may be able offer big-ticket items like their car or a savings account to secure a loan. This is referred to as collateral and comes with its own risk. If the loanee is not able to pay back the loan, they will lose whatever asset they’re pledging.

: There are online lenders that work specifically with those with bad credit. These lenders have looser requirements than banks and they will consider other factors besides credit score. However, the interest rates of online lenders can be high when you have poor credit as they have annual percentage rates typically above 20 percent.

Author bio Jackie Veling covers personal loans for NerdWallet.

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