What Are Your Obligations When Cosigning a Loan?
A cosigner is responsible for the loan if the primary borrower does not pay back what he or she owes. Cosigning a loan can really help a friend or family member, but it can also put your credit and financial well-being at risk. Here’s what you need to know about your obligations.
What does cosigning a loan mean?
When you cosign a loan, you provide your good credit to help someone else who has a poor or limited credit history buy a first home or car, or qualify for a personal loan. This means you also take responsibility to repay the loan if the primary borrower is unable (or unwilling) to do so.
A loan is a legal agreement, and cosigning one comes with significant risks.
“When you’re the cosigner, you’re liable for the whole loan,” said Dennis Nolte, a certified financial planner and vice president at Seacoast Investment Services in Oviedo, Fla. “The underwriters always go to where the money is. The buck stops here, literally.”
As a cosigner, you guarantee the primary borrower’s debt. This means you’re obligated to pay the full amount if the borrower can’t or doesn’t due to job loss, financial hardship or even death.
In many states, creditors can come after the cosigner without even trying to collect the debt from the primary borrower. They can sue you or garnish your wages — in some cases, you’ll have to pay the loan amount plus interest, late fees and collection costs.
3 big risks to cosigning a loan
When you attach your name and credit history to a loan contract, you take on a certain amount of legal, financial and personal risk. Here are three major risks to keep in mind:
Risk No. 1: Damage to your credit
If the borrower you’re cosigning for defaults on his or her loan, that reflects poorly on your credit score just as it would if you failed to pay back a loan in your own name. But there are other ways cosigning a loan can affect your credit.
For example, taking on more debt can increase your credit utilization, which is a ratio of how much of your total available credit limit you’re using. Using more than 30% of your available credit will likely lower your credit score.
Cosigning a loan may also increase your debt-to-income ratio (DTI), which is the total debt you have to repay each month relative to what you earn. Your DTI won’t influence your credit score, but it may affect your ability to qualify for additional credit.
Late or missed payments could negatively affect your credit score, even though the primary borrower is receiving the bills. Request regular updates from the lender if possible, and check in with the borrower to ensure they’re on top of payments.
Risk No. 2: Significant debt or loss of property
If you secure a loan with your car, home or other valuable asset, you run the risk of losing your property, should the primary borrower default. The lender can seize and resell your collateral, and come after you for any additional funds required to pay off the debt.
If a lender can’t take any assets, it will likely sell the account to a collection agency, which means you’ll have to deal with the original debt plus interest, fees and damage to your credit history.
Risk No. 3: Strain on personal relationships
Being a cosigner is a major commitment that can last years, or even decades in the case of a traditional 30-year mortgage. If you fall out with your brother a year after cosigning his personal loan, you’re still responsible for that debt. Being financially tied to a loved one can also put stress on an otherwise healthy relationship: Imagine how you’d feel if your adult child or close friend stopped making payments on his or her loan and left you with thousands of dollars of debt to cover.
How to protect yourself
Before you cosign for a friend or relative’s loan, consider taking the following steps:
- If possible, negotiate the loan terms to limit your liability or minimize fees or additional charges you’re responsible for.
- Ask the lender to let you know if the borrower misses payments or the loan terms change.
- Request copies of the loan contract, disclosures and warranties.
As an alternative to cosigning, Nolte suggested giving the borrower money upfront if possible, such as making a down payment for a home or buying a car outright. This may be a gift or a loan, but a short-term agreement with clearly defined rules might be a better use of credit than getting locked into a 30-year mortgage, he said.
Cosigning is just one way to be connected to a friend or family member’s finances. There are two other agreement types you might encounter that carry slightly different (and perhaps less risky) responsibilities than cosigning a loan.
With a joint account, you are a co-borrower with another person, which means you both own the account and are responsible for its debt. This is a common setup for couples who combine their finances. There are pros and cons to joint accounts, which can help couples stay better organized and save on fees, but can also cause problems if one partner is financially irresponsible.
If you’re an authorized user, on the other hand, you can use the account but are not liable for it. A student may be an authorized user on a parent’s credit card, for example — the student can make purchases with the card but isn’t legally bound to manage its debts.
How to get off the hook
There are only a few ways to get out of the commitment you make when you cosign a loan — unfortunately, none of them is easy.
The first option is to pay off the loan. Either you or the primary borrower may do so, but once the loan is satisfied, you’ll no longer be responsible for it.
The next option is to request to have your name removed and the responsibility transferred to the borrower. Once the borrower has made payments for a certain amount of time, the lender may let you off the hook — but this varies from lender to lender.
The final option is to have the borrower refinance the loan. If they’ve made regular, on-time payments, they may then be able to qualify for credit on their own. Of course, a borrower may be more likely to refinance a long-term contract, such as a 30-year mortgage, than a short-term personal loan.
To cosign or not to cosign
The main reason to cosign a loan is to help someone close to you who can’t obtain credit on their own. As long as you can afford the loan, have full knowledge of the risks and set clear expectations for repayment with the primary borrower, this can be a worthwhile commitment.
“Of course you’re going to make that loan for the people that you love,” Nolte said. “Knowing what you’re liable for and what you’re not will help you make that decision.”
But think with your head, not your heart: If you can’t afford to repay the loan or will lose valuable assets if the borrower defaults, cosigning likely isn’t a smart move.