Co-signing a Loan: Risks and Benefits

You may be asked to co-sign a personal loan for your spouse, child or friend, especially if your credit score outshines theirs.

But what sounds honorable — helping someone get money for debt consolidation or home improvements — can have consequences you may not expect.

A co-signer is someone who adds their name, credit profile and financial information to the primary borrower’s loan application, agreeing to be legally responsible for the loan amount, and any additional fees, should the borrower be unable to pay.

Most people want or need a co-signer because they can’t qualify for the loan by themselves. If you have a strong financial profile, co-signing for someone with a lower credit score or thin credit profile can improve their odds of qualifying or snagging a lower interest rate.

Unlike a joint loan in which two borrowers have equal access to the loan, in a co-signed loan, the co-signer has no right to the money even though they could be on the hook for repayment.

Risks of co-signing a loan

Co-signing on someone else’s loan puts you in a uniquely vulnerable position. Here are the risks to consider.

This is the biggest risk: Co-signing a loan is not just about lending your good credit reputation to help someone else. It’s a promise to repay their loan if they are unable to do so, including any late fees or collection costs.

Before you co-sign, assess your own finances to ensure you can cover the loan payments in case the primary borrower cannot.

When you co-sign a loan, both the loan and payment history show up on your credit reports as well as the borrower’s.

The lender’s hard credit check during the loan approval process will temporarily lower your credit score by a few points.

Most important, though: A missed payment by the borrower can negatively affect your credit score. Since payment history has the biggest influence on credit scores, a misstep here can wreck your credit.

The long-term risk of co-signing a loan for your loved one is that you may be rejected for credit when you want it. A potential creditor will factor in the co-signed loan to calculate your total debt levels and may decide it’s too risky to extend you more credit.

Your debt-to-income ratio — the percentage of your monthly income that goes toward existing debts — is a major factor on many credit applications.

In some states, if the lender does not receive payments, it can try collecting money from the co-signer before going after the primary borrower, according to the Federal Trade Commission.

To get to that stage, the borrower would likely have missed several payments, and the debt would already have started to affect your credit. Lenders are likely to consider legal action when the debt is between 90 and 180 days past due.

If the worst happens and you are sued for nonpayment, you’re responsible for all costs, including attorney’s fees.

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

If the borrower falls behind on payments, your credit score can drop and lenders might go after you for payment. The negative impact on your finances can create friction between you and the borrower.

If issues arise, you may not be able to remove yourself as the co-signer.

Not all lenders allow a co-signer to be released from a loan. Those that do may require a credit check of the main borrower to ensure they are individually viable to make the payments on their own. Personal loans typically require a certain number of on-time payments before the lender will reassess the primary borrower to see if they can make payments on their own.

Benefits of co-signing a loan

The upside of co-signing for someone is obvious — you can help them qualify for a personal loan or other financial product they could not get on their own, or save them interest with a lower rate.

When someone has a thin credit history or is rebuilding their credit, having a co-signer with a good score and an established credit history is powerful.

Not all personal loan lenders allow co-signers, so it’s worth checking before you apply.

Does co-signing a loan build credit?

Here’s how being a co-signer can build your credit:

• As long as payments are made on time, it adds to your payment history. However, if you have a high score and well-established credit, the effect may be small compared with the danger to your score if the borrower doesn’t pay.

• Your credit might get a small benefit if  the loan improves your credit mix. It’s useful to have both installment loans (with level payments) and revolving accounts (like credit cards).

Here’s how the person you co-signed for can build their credit:

• It can help them qualify for credit they otherwise would not get, boosting a thin credit file.

• Making on-time payments on the account builds positive payment history.

How to protect your credit if you co-sign a loan

Before you co-sign, ask the lender what your rights and responsibilities are and how you’ll be notified if payment issues arise.

Write out a plan with the borrower that spells out the expectations for each person. You can ask the borrower for access to the loan account so you can keep tabs on when payments are made.

Alternatives to co-signing a loan

If you don’t want to co-sign a loan, there are other options available for the borrower:

• Family loan: If the borrower was hoping to have a family member co-sign for them, they could opt for a family loan instead. A family loan doesn’t involve a third-party lender, so there’s no formal application or approval process, but it should include a notarized, written agreement between the two parties summarizing terms. Family loans can help borrowers get cheaper loans and avoid predatory lenders, but they still put another person’s finances at risk if the borrower is unable to repay the loan.

• Secured loan: A borrower might be able to offer big-ticket items like their car or a  savings account as collateral on a loan. This is known as a secured loan and comes with its own risk. If the borrower is unable to make payments on the loan, the lender will take the pledged asset.

• Bad-credit loan: Some online lenders work specifically with applicants who have bad credit. These lenders have looser borrowing requirements than banks and may evaluate other factors, like education and where you work, in addition to your credit score. However, bad-credit borrowers are typically offered the highest annual percentage rates, typically above 20%.