Why You Should Never Co-Sign a Loan

There are times when co-signing a loan seems like the right thing to do. It could be to help a young adult child get a car loan or a mortgage to buy a house. Or it could be helping a family member or friend re-establish credit after a bankruptcy or foreclosure. As good as any reason may be, and as good as your intentions are, think long and hard before you co-sign a loan for anyone.

There are consequences to co-signing a loan that go well beyond the realm of a family relationship or friendship. Anytime you co-sign a loan for another person, you are in some way compromising your own financial position.

A Co-Signed Loan Becomes Your Obligation

Most people in a non-lending world think of co-signing a loan as something more of a gentleman’s agreement. In fact, many people completely forget about a co-signed loan shortly after the fact. But rest assured that from a legal and financial standpoint, it carries significant meaning.

When you co-sign a loan it automatically becomes your obligation. If you later apply for a loan for yourself, the co-signed loan will appear on your credit report under your name. The entry may be notated as a co-signed loan, but the lender will view it as fully your obligation. They will consider the monthly payment on the loan as if it were being paid by you, even if it isn’t. It will be added to your total debt payments, and calculated as part of your debt-to-income ratio. It is even possible that you will be denied a loan because of the co-signed obligation.

Certain lenders, such as mortgage lenders, consider co-signed loans to be contingency obligations. They will allow you to exclude the payment from your total debt if you can get evidence that the primary borrower on the loan has made all of the payments, and made them on time, for at least the past 12 months. But if the loan has been outstanding for less than 12 months, or if there are any late or missed payments, or if you have made one or more payments yourself, the debt will be considered as it were yours alone.

The Affect on Your Credit Report

Since a co-signed loan is a credit obligation, it will appear on your credit report. That can have an effect on your credit scores. New loans, and loans with high outstanding balances compared to the original loan amount will have a negative effect on your credit scores (credit utilization). You can fully expect some drop in your scores as a result of co-signing a loan.

Late Payments by the Primary Borrower

Should the primary borrower be late with any payments, whether it is 30 days late, 60, or 90 days late, it will appear as such on your credit report and have an even bigger negative effect on your credit score.

Credit scoring does not differentiate between loans that are actually yours, and those on which you are only a co-signer. Any derogatory information will reflect on your credit scores as if you were the cause of the problem.

Even if the co-signed loan is paid off, the derogatory information will continue to appear on your credit report for at least seven years (and the primary borrower’s too). During that time it will have a negative effect on your credit scores. Even if the rest of your credit is outstanding, the delinquent information on the co-signed loan will continue to weigh on your credit scores.

Co-Signed Loans Will Become Your Responsibility Upon Default

Should the primary borrower default on the loan, the lender will come after you to payoff the account. That’s the entire reason why the lender wanted a co-signer on the loan in the first place!

Now ultimately you may be able to go after the primary borrower to reimburse you for the money you had to pay to settle the account. However the default will still appear on your credit report for at least seven years. Once again, the credit reporting agencies will not remove the derogatory information simply because you settle the account.

Better Ways to Help

If a loved one needs financing – and your co-signature – in order to accomplish a certain goal, there may be better ways to help without co-signing.

If you’re in a position to do so, it will be better if you make them a personal loan. You can set it up with a note, including interest and monthly payments. That will mean you’ll have to put money out of your own pocket, however if the primary borrower defaults on a co-signed bank loan, you’ll have to do that anyway.

Another option is to convince them to buy something less expensive that will not require the use of a loan. Failing that, recommend that they delay the purchase until they can save up more money so that they don’t need a loan – or a co-signer.

Co-signing a loan for loved one is only convenient at the moment that you do it. After that . . . is when the trouble starts.

Have you ever co-signed a loan for someone? Leave a comment and tell us a little about it!

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

All posts by Kevin Mercadante