What Happens When You Cosign a Loan?
Cosigning on a loan for another person may not seem like a big deal, but the potential financial implications for you could be serious and long term. Often, people think that as the cosigner, they’re not really responsible for the terms of the loan and are more just offering a nod of confidence to help push the borrower over the line. This could not be further from correct.
When you cosign a loan, you are responsible for the full repayment of the loan according to the terms of the lender if the person who is borrowing the money defaults. That makes it a risky proposition for you, one you should weigh the pros and cons of before signing on the dotted line — literally.
Yes, there are some situations where cosigning a loan for a friend or a family member may be all right, but you have to make sure you know what you’re signing up for before putting pen to paper.
Should you be a cosigner?
The ultimate decision on whether you should cosign on a loan or not will be up to you, but before you decide, understand what you’re signing up for. When you cosign on a loan, you are agreeing to be 100% responsible for all terms of that loan if your friend or family member stops making payments. Contrary to popular belief, cosigners are not responsible for a smaller portion of the loan than the primary borrower. In the eyes of the lender, the law and the credit bureaus, you are the same as the primary borrower.
What happens when cosigning a loan?
Your debt goes up, and your credit score goes down.
When you cosign a loan, your friend or family member’s debt is immediately added to your credit profile. You are not tagged with the debt only if they default; it’s immediately attributed to you. What does this mean? Two things.
First, your credit score is going to go down. Your FICO credit score (the score most often used by lenders) factors the amount owed on the loan as 30% of your score, and new credit accounts make up 10% of your overall score. When you cosign, you’ll add all of that debt to what you owe on your own accounts, and you’ll be tagged for opening a new credit account.
Additionally, your debt to income ratio is going to change. If you try and get a loan like a mortgage, you may not be able to get approval because your debt is now significantly higher. Helping your friend or a family member achieve their financial dream may postpone yours.
Your long term credit score is at risk.
Not only will your credit score go down immediately, but you risk the loan having a much greater impact on your score over the long run. If the primary borrower stops making payments or defaults on the loan, you’re left with a tough choice. You can start making the payments for them, or you can watch your credit score crumble. The lender will hold you equally responsible for the missed payments. Doesn’t seem fair? It’s what you sign up for when you cosign on a loan.
You can get sued.
Banks, credit unions and lenders are not charitable organizations. They exist to make money. When the primary borrower stops paying, the lenders will do whatever they need to recoup the money. If the primary borrower has already demonstrated they can’t or won’t pay, you become the most likely to pay.
If you cosign on a loan and the primary borrower stops paying, you could get sued by the lender for payment. This is on top of the damage that the missed payments are going to do to your credit score. Can you imagine being told by the courts you have to pay the remainder of your friend or family member’s loan? If that’s not something you’re comfortable with, stay far away from being a cosigner.
You don’t have much to gain.
Will your friend or family member be thankful you helped them? Absolutely. Will you get warm and fuzzies when you see them in their new car or house? Absolutely. However, that’s the extent of what you have to gain when cosigning on a loan. Outside of goodwill, you’re not going to see much else positive in your financial picture.
You don’t get paid, and you don’t earn special interest. It’s a lot of risk for not a lot of rewards.
You will help your friend or family member.
There may be a few situations where cosigning could help. If it’s a unique situation where you want to help someone close to you, and you are willing to accept the risk, then go for it. You just need to fully understand what you’re signing up for and all of the associated risks before moving forward. It’s a risky financial move, but it does have its time and place.
For example, parents sometimes cosign loans for their children early in life to help them get a better interest rate or when help out when they have a lack of credit history. This may be a situation where the parents are willing to accept the risk of the kids defaulting in exchange for better rates and approval. Again, each cosigning situation should be approached on a case by case basis.
Your friend or family member may try and convince you that cosigning is not that big of a deal. Additionally, no one is going to approach you about being a cosigner by telling you there is a 0% chance they will be able to make all the payments on time, in full. The problem is that not everyone can predict what life has in store for them. If you’re fine with accepting the risk of being liable for a loan without a lot of reward, then go for it.
But before you do, make sure you 100% understand the terms of what you’re signing up for. You are now responsible for every single term in that loan. Read through the loan as if it were your own, because when you sign — it is your loan, too.