If you co-sign a credit card or a loan you are taking a very real risk. A 2016 survey found that almost 40% of co-signers ended up paying off some portion of the debt that they had signed for. 28% reported a negative impact on their credit score and 26% said their relationship with the other person was damaged.
Co-signing can help a loved one, and that’s an appealing prospect. The risks are still serious enough to warrant caution. Let’s take a closer look at what co-signing really means, so you can mitigate the risks and make an informed decision.
What Does it Mean to Co-Sign a Credit Card or Loan?
Co-signing is a way for people with poor credit or a thin credit file to use loans or credit cards that they wouldn’t be able to get on their own. If a person with better credit co-signs the loan or card application, the borrower may be approved or given better terms on the co-signers signature’s strength.
When you become a co-signer on a credit card or loan, it’s usually because you help a family member or a friend obtain a financial service they couldn’t otherwise get. Your strong credit score can help someone with poor or nonexistent credit get substantially better terms on a credit card or loan or even get approved by a lender.
If you decide to co-sign, you will be financially and legally responsible for the debt. It will appear on your credit report and affect your credit score. It will also count toward your debt-to-income ratio. You will have to pay the debt in full if the borrower can’t make the payments.
☝️ The key point to remember is that a borrower’s credit score is a numerical representation of their likelihood of default: the lower the score, the higher the risk. If the risk is too high, lenders won’t approve the loan or card. When you co-sign, that risk falls on you. Usually, you consider taking that risk because the person is important to you, and those feelings may lead you to overlook the risks.
In my experience working in the banking industry, the most common types of financial products clients co-signed for were credit cards, car loans, and student loans. It was often parents helping their children who hadn’t built enough strong credit to qualify for these products alone.
Before You Co-Sign a Credit Card or Loan
Co-signing is a big responsibility, and there are several key questions you should ask yourself first.
- How well do I know the borrower?
- Is the borrower financially responsible? Will they be committed to making payments on time and keeping the credit card or loan in good standing?
- How will this affect my credit and my debt-to-income ratio?
- Can I afford to pay this loan if the burden falls on me?
- Will I have access to monthly statements to make sure the account is in good standing?
In short, you want to know that you’re unlikely to become responsible for the loan and stable enough to take it on if you have to.
Advantages of Co-signing
The survey cited earlier also found that 1 in 6 Americans have been co-signers at some point in their lives. 78% of those cosigned for a family member, with 45% cosigning for a child or stepchild. 21% cosigned for friends.
Parents will often co-sign to give their kids a helping hand early in their life and career. Whether it’s a student loan for college or their first credit card, you will go above and beyond to see your loved ones thrive. My father co-signed for my student loan and my first car loan, and I am extremely grateful.
While the benefits are mostly for the main borrower, the co-signer can also reap some benefit. If the credit card or loan is paid on time and in good standing, it can further help you build a good credit score or diversify your credit mix.
Risks of Co-Signing
Even though there are some advantages to you and many benefits for the primary borrower, there are also risks that you must consider.
You are Financially and Legally Responsible
If you cosign, you will be fully responsible for the loan or credit card. If the other borrower stops making payments for any reason, you will have to pay the balance yourself.
⚠️ The lender can sue you if the primary borrower fails to pay.
Your Debt-to-Income Ratio
If you cosign a loan your debt-to-income ratio will be affected. The monthly loan payment or the minimum monthly payment on a credit card will be added to your monthly obligations. That will push your debt-to-income ratio higher, even if you’re not making the payments.
Your debt-to-income ratio is an important factor in determining your eligibility for many loans, especially mortgages. Most mortgage lenders prefer to see a debt-to-income ratio under 36%, and most won’t lend at all if your debt-to-income ratio is over 43%. If you’re thinking about getting a mortgage anytime soon, you will want to calculate the impact of cosigning on your debt-to-income ratio.
Your Credit Score is On the Line
Your credit score will take a hit if there are any late or missed payments. You may also be charged with late payment fees and penalty fees if this happens.
Even if the borrower has the best intentions, outside events can affect their ability to pay. Medical expenses, job loss, divorce, and other life events are responsible for many delinquencies. The lender or card issuer won’t care why the delinquency happened. You’ll still be responsible for the debt.
You’re Locked In
It is almost impossible to remove yourself from an account once you’ve signed the papers. The only way to get out of the commitment is to close a credit card account or refinance (or pay off) a loan.
If you’re co-signing for your spouse or significant other, don’t expect to get out of it if you divorce or separate. Your bank or lender will still consider you responsible for the loan even if your relationship is officially over.
It Can Affect Your Personal Relationship
Co-signing a loan or credit card can damage or destroy a personal relationship. If the financial relationship turns bad, the stress on the personal relationship is likely to be considerable.
Before you consider co-signing you’ll need to consider all of these factors and communicate openly with the other party. If everyone’s on the same page there’s a better chance of avoiding both financial and personal problems.
Before You Co-Sign a Credit Card or Loan
Once you’ve decided to co-sign a credit card or loan, you should take all possible precautions to ensure that things go as smoothly as possible. Here’s what you need to do before you commit.
- Make sure you have access to monthly statements.
- Ask the lender if they offer a co-signer release. Many private student loan issuers will offer a release if you meet certain criteria.
- Ask the borrower to agree to refinance the loan solely under their own name once they can. If he/she agrees to this, ensure the lender offers this as an option.
- Be fully involved in all meetings with your lender and carefully read all documents. Ask questions and keep copies of everything.
Once the deal is signed, don’t just assume that things are going well. Check the account statements and make sure the borrower is making payments on time and not running up a balance on a co-signed credit card.
☝️ Keeping track will let you take action early if things go wrong. You don’t want your first hint of a problem to be a call from a collection agency!
These steps may seem intrusive, but they will protect both your credit score and your relationship with the borrower. Borrowers who understand the commitment you’re making should understand why you need to be involved. If they don’t, consider that a warning sign.
Alternatives to Co-Signing
If you decide to not go through with co-signing, make sure to use empathy when explaining your decision to the borrower. Try to offer other ways to meet their needs.
- If you have the means, it may be safer to offer a temporary loan, depending on their needs.
- Make them an authorized user on your credit card. They will have access to a credit card until they can apply for their own without needing a co-signer. Some issuers will include authorized users in their reports to the credit bureaus, which will help the borrower build credit.
- Offer to help them apply for a secured credit card. This card is designed especially for people that want to build credit or fix their credit. Offering to pay the deposit on a secured card carries much less risk than co-signing a conventional credit card.
If the main goal is to help the borrower establish their own credit rating, look into some other ways to build credit. You may also be able to find other options by speaking with an accountant or financial adviser.
Co-signing a loan or credit card is a generous choice that can help someone close to you. But before you make this decision, remember to ask questions, consider the risks, and take all possible precautions to assure that the relationship is satisfactory for both you and the borrower.