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7 risks to consider before cosigning a loan
You could get sued if the borrower fails to repay.
Risk #1: You could hurt your chances of getting a loan you need.
Cosigning a loan automatically increases your debt-to-income (DTI) ratio, which weighs your monthly debt obligations against your income. This alone can make it difficult to qualify for a loan, meaning you might have to put that mortgage, car loan or plans to refinance your own debt on hold.
After your credit score, your DTI is one of the most important factors lenders consider on your application. Ideally, your DTI should be below 20% if you want a competitive rate. And most lenders won’t work with you at all if your DTI is above 43%.
Risk #2: It could damage your credit.
Cosigning a loan means you’re as responsible for making repayments as the borrower. If the borrower misses a repayment or defaults, that damaging mark goes on your credit report, too. A flag like this can stay on your report for up to seven years after the first missed repayment.
To avoid this, regularly check in with the loan account to make sure the borrower is making repayments on time.
Risk #3: You might have to repay the loan in full.
If the borrower loses their job or otherwise can’t handle repayments, they’re your responsibility now. You also might have to take full responsibility for the loan if the borrower dies and their estate can’t cover it.
Only cosign a loan if you’re prepared to take over repayments. If you’re really worried about affording that expense, some experts suggest taking out a life insurance policy on the borrower so you’re protected in the event of their death.
Risk #4: It’s hard to get off the loan if you change your mind.
Once you’re a cosigner, there’s little you can do personally to take your name off the loan. The only way to get out of the responsibility is to have the borrower refinance in their own name.
With some types of loans, such as student loans, they might also have the opportunity to apply for cosigner release. This allows them to keep the same loan but takes your name off of it.
However, this might be an unlikely option if the borrower has weak personal credit or lacks sufficient income to afford repayments on their own. In other words, refinancing and cosigner release won’t help you if the borrower is struggling to make repayments.
Risk #5: You might get sued.
If the borrower defaults on the loan and doesn’t make collections payments, both you and the borrower could face a lawsuit. In fact, you might face a lawsuit before the borrower since it’s your responsibility to repay the loan if the borrower reneges. If you lose, you could get a court order to repay the loan in full.
Risk #6: You might have to pay extra taxes.
If you and the borrower can’t repay the loan, your lender might agree to settle the debt for a lower amount instead of going through a lawsuit. You might have to pay taxes on the amount that gets forgiven since the IRS considers most cases of debt forgiveness as taxable income.
Risk #7: Your relationship could get damaged.
If the borrower acts irresponsibly and drags your credit score and finances down with them, it can seriously damage your relationship. Rebuilding that trust can be difficult and take years to come back from. If that’s too much of a risk for you, it might not be worth cosigning a loan.
When might I want to cosign a loan?
Despite the risks, you might want to cosign a loan in the following situations:
- Share a responsibility. If you and your partner are buying a car, home or investing in something you equally benefit from, cosigning a loan is a good way to make sure you’re really in it together.
- Support a child. It’s common to cosign student loans or your child’s first car loan to help them transition into independence. It gives them the chance to learn the responsibility of paying back debt while building a credit score so they can qualify on their own later.
- Help someone back on their feet. Medical emergencies, divorces and other unforeseen circumstances can wipe out someone’s finances through no fault of their own. Cosigning a loan for friends or family facing tough times can help them get back on their feet.
- Support someone who’s new to the country. If you have a friend or relative that recently immigrated or is on a visa, their borrowing options are limited since they likely don’t have a credit score yet. Cosigning can help them cover the cost of making such a big move while also giving them a path to financial independence.
4 tips to protect yourself as a cosigner
Keep these pointers in mind to avoid damaging your finances with a cosigned loan:
- Check your state laws. Cosigners might have different responsibilities depending on where you live. Research your state laws before cosigning a loan so you fully understand what you’re taking on.
- Stay on top of repayments. You can avoid most of the risks that come with being a cosigner by staying on top of repayments. Ask the lender if they have any tools that can help you with this, such as alerts if a repayment is missed.
- Have a plan if you have to repay. If you don’t think you can fit repayments into your budget, being a cosigner isn’t the best idea. The loan could do some serious damage to your personal finances and credit if the borrower drops the ball.
- Take care of your personal needs first. If you need to take out a loan, do it before you cosign. Even if you don’t have to take the reins, you’ll still have a higher DTI until the loan is paid off.
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Cosigning a loan comes with more risks than rewards. But there are a few situations where the social benefits may outweigh the potential costs. If you do decide to cosign, be sure to stay on top of the borrower’s repayments.
You can learn more about how borrowing works with our guide to personal loans.
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