If your friends or family members ever ask you to cosign for a loan – any loan – give this decision plenty of thought before you say “yes.” You might even consider just making a gift instead or borrowing the money yourself. Statistically speaking, that’s quite likely what you are going to end up doing. According to a survey conducted by creditcards.com, almost 40 percent of cosigners found themselves paying some or all of a loan or credit card balance when the primary borrowers they were helping did not make payments.
Unless the borrower is a close family member or a very good friend, “no” is generally your best answer. Even then, the borrower for whom you cosign on a loan should be someone you will be very close to for a long time or at least until the loan is repaid. At the very least, this decision could make for some awkwardness at family gatherings and social events. At the very worst, you could end up getting sued by a lender to repay someone else’s debt obligation.
Why would someone ask you to cosign in the first place?
When a borrower can’t obtain credit on their own, it is often due to a lack of credit history (i.e., a young or first-time borrower) or because they have a low credit score due to delinquent payments, charge-offs, or similar negative credit events. In some cases, the borrower may receive a credit offer but at a prohibitively high interest rate. A lender may suggest to the borrower that if he or she can find a cosigner who does have a strong positive credit history, they can then qualify for the loan. The types of loans that may require or benefit from a creditworthy cosigner include auto loans, mortgages, credit cards, and private (not federal) student loans.
How does cosigning affect credit scores?
Once you cosign for a loan, the debt will appear on both of your credit reports. Accordingly, the loan can help both the primary borrower and the cosigner build a positive credit history, assuming all payments are made on time. The opposite can also be true if the primary borrower begins missing payment deadlines.
According to credit reporting bureau, Experian, the cosigner is contractually obligated to make any and all payments that become delinquent (late). Therefore, late payments on the loan can also lower the credit scores of both borrower and cosigner. It is also important to remember that as a cosigner, the amount of credit extended to the borrower also counts as an open line of credit on your credit report, potentially making you appear to be a greater credit risk to your own lenders.
Wait. It gets worse.
If things go south and the primary borrower cannot keep up with payments, a lower credit score is not the only headache awaiting the cosigner. Unless you communicate closely with the primary borrower, your first hint as a cosigner that something has gone wrong is often a collections call or past due notice in the mail. At this point, the damage is done.
A late or missing payment has landed on your credit report and will remain there for several years. As a cosigner, the lender now expects you to pay and will continue to treat the loan as if you had borrowed the money yourself (which you did). Unfortunately, you now have nothing to show for this debt obligation, except a rapidly declining credit score and some unwanted discussions with collections representatives.
Private student loans may be particularly troublesome to escape as a cosigner. Unlike federal student loans, private student lenders frequently require a cosigner since student borrowers are often young and without a credit history or income. Private student loan lenders may include a cosigner release option, although not all of them are clear on exactly what criteria must be met in order to release the cosigner from the loan obligation. SallieMae, one of the largest private student loan lenders, does publish a set of 10 conditions that must be met before a student loan borrower can petition to have his or her cosigner released from the loan obligation. A report from the Consumer Financial Protection Bureau (CFPB) states, however, that about 90% of borrowers who request cosigner release are rejected.
How can you manage your risks as a cosigner?
Know your borrower. Despite the risks, if you still choose to become a cosigner for someone else’s debt obligation, know your borrowing partner well – very well. As we’ve seen, cosigning a loan for a close friend or family member can often be a bad idea. Cosigning for a co-worker, a casual acquaintance, or (do I have to say it?) a stranger should always just be an automatic “no” on your part.
Review your budget. If the primary borrower defaults on the loan, can your budget handle the added strain of making the loan payments until it is fully paid? Be prepared if that happens. Suggest – or insist – the primary borrower also reviews his or her budget to give you some level of confidence in their ability to repay the debt obligation. If either of your budgets would struggle under the new loan payments, pass it by and look for another way.
Get copies of everything. In addition to copies of the loan documents themselves, request to have duplicate statements sent to you or obtain login credentials so you both always know the status of debt payments.
Get out as fast as you can. There are two ways you can extricate yourself from your role as cosigner and you should do so at your earliest opportunity. One method is to have the primary borrower agree to refinance the loan under his or her own name at some point in the future when their finances are better developed. This could be a simple handshake agreement, but a written agreement between the two of you is much stronger.
Some loans, such as private student loans, may include the option for a cosigner release. This release typically is not automatic and specific conditions must be met, such as making a specific number of on-time payments. Either the primary borrower or the cosigner should request a cosigner release form from the lender to begin the process. The CPFB has sample letters that borrowers and cosigners can use to make this request.
Finally, ask yourself and your struggling borrower if you have fully considered all alternatives to using a cosigner to obtain the loan. Are there other sources they can tap into? As a cosigner, both your good credit and your hard-earned cash are at risk.