It might seem like a nice thing to cosign a loan for a family member or friend, but there are potential severe long-term consequences that you should consider first. From hurting your credit score to straining your relationships — cosigning a loan is more than just signing a document.
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Here are seven hidden financial risks that you need to be aware of before choosing to cosign a loan.
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Credit Score Impact
When you cosign a loan, it gets added to your credit report. This can impact your debt-to-income ratio and the hard credit inquiry when processing the loan application can lower your credit score.
But the bigger risk is if the person that you’re cosigning a loan for stops making payments. Since you are responsible for the loan just as much as the main borrower, late or missed payments will directly impact your credit score.
And if the loan goes into default this can severely hurt your credit. So, make sure you 100% trust the person you are cosigning for to continue making on-time payments otherwise your credit score may be in jeopardy.
Unpaid Debt
When you cosign on a loan, you’re not just lending your credit history and score to help someone qualify for a loan or get a better rate. You’re actually signing up as a responsible party on the loan itself.
This means if for some reason the borrower you cosigned for cannot make payments — you will need to start making payments (or risk hurting your credit score). And if the borrower simply stops making payments altogether, the creditor can legally go after you (and your assets) to collect on the loan.
Limited Control Over Loan Funds
As a cosigner, you are using your credit score and history to help someone qualify for a loan. But that doesn’t mean you get to choose what to do with the loan funds — the loan proceeds are sent to the main borrower directly.
That means you can’t control if your friend or family member decides to blow the money or use the funds for something other than what you discussed. It also means that you are still responsible for the loan if they decide to stop paying even if the funds were used for things you don’t agree with.
Impact on Your Borrowing Ability
When you cosign for a loan, the loan amount is actually added to your credit report and increases your total debt load. This can impact your ability to borrow in the future for things like an auto loan, home loan, or a personal loan.
When lenders look at your credit report, they can see outstanding debts and payment amounts. The cosigned loan — even though it’s not your money — will be part of your report and lenders may deny you a loan if it puts you over a reasonable debt-to-income ratio (DTI).
Strain on Your Finances
As a cosigner, you are technically a responsible party for the loan payments. If your friend or family member can’t make the payments, you may have to step in to start paying on the loan. This can put a severe strain on your finances if you don’t have the money available each month to pay on the loan.
If you choose to stop paying, it can hurt your credit score and you can still get sued by the lender — which could result in paying even more with penalties and fees.
Strain on Your Relationship
If your friend or loved one falls on hard times and can’t make payments, it could make for a difficult situation. If you have to start making payments for them, or if you find out the funds were used in a way you disagree with, it could cause anger or resentment in your relationship.
If you don’t want to risk your relationship with the person you cosign for it may be better to avoid it altogether.
Removing Cosigner Status
If you cosign on a loan with the plan to be removed from the loan in the future it might not be that easy. Most lenders require on-time payments on the loan for a number of years before you qualify to be removed and some lenders don’t offer a cosigner’s release at all.
Make sure that you review the loan terms and conditions on cosigning before applying and ask about a cosigner’s release before completing the loan.
How to Protect Yourself If You Cosign a Loan
If you still decide that you want to cosign on a loan, it’s a good idea to protect yourself. Here are a few things you can do to protect your finances (and your relationship) when cosigning a loan:
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Read the fine print. Make sure you understand the details of the loan, including what happens if the borrower defaults, and if there’s a co-signer’s release available.
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Create a written agreement. Outside of the loan documents, create a written agreement between you and the borrower to ensure both parties understand what is expected, and what happens if the borrower can no longer pay.
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Keep an eye on the loan. Ask for access to the loan dashboard so you can log in and make sure the loan doesn’t end up in default. Or have the lender send you monthly statements.
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Be prepared to pay. While it’s expected that the borrower will repay the loan it’s a good idea to make sure you have the means to pay the loan should something happen.
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Sources:
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Consumer Financial Protection Bureau, “3 things you should consider before co-signing for an auto loan“
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Consumer Financial Protection Bureau, “Should I agree to co-sign someone else’s car loan?”
This article originally appeared on GOBankingRates.com: 7 Hidden Financial Risks of Being a Cosigner
