In some cases, it's difficult for a borrower to gain approval for a loan. This can be due to poor credit, or even just due to insufficient credit history. When one of your friends or family can't get a loan, they might ask for a co-signer.
If you have good credit, you can co-sign on the loan with the borrower, and the lender will provide the money, since you are considered financially trustworthy. But, even if you might want to help a loved one by co-signing, you really should think twice. Co-signing a loan is a big commitment, and it's one that have a bigger impact on your finances than you might think.
How Co-Signing Works
If a borrower doesn't have credit that the lender trusts, a co-signer can also take responsibility for the loan. And it's important that you realize that, as a co-signer, you are taking responsibility for the debt. When you co-sign on a loan, you agree to pay the debt if the borrower defaults. So, even though the borrower is supposed to make the payments, if he or she flakes out, you are stuck with the debt, since you agreed to be responsible for it.
How Co-Signing Affects Your Finances
In a perfect world, you co-sign for your loved one, who really just needs a little bit of help getting back on his or her feet, and the borrower makes all the payments, and eventually the loan is paid off, and everyone is happy.
Even if things work out like this, though, your finances as co-signer are still affected. Since you are agreeing to be responsible for the debt, it shows up in your credit report. So, your credit history shows that you have this debt. Even though it's not your loan, and you aren't paying on it, the reality is that it still affects your credit situation. You might not be able to qualify for your own loan because of the debt load it appears you have as the result of co-signing.
Of course, if things don't work out, and the borrower ends up missing payments and/or defaulting, you are in even worse shape. Your credit score is dinged as a result of the borrower missing payments. You become responsible, and the creditor can come after you for payment on the loan, even deciding to turn it over to collections at some point. All of this can drag on your credit score.
Before You Co-Sign A Loan
In many cases, it makes better financial sense to just avoid co-signing a loan for anyone. If you decide to co-sign, though, you want to make sure that you protect yourself as much as possible. Evaluate the borrower. Do you really trust him or her to make payments on time? Make it clear, too, that if something happens and he or she is going to have trouble fulfilling the obligation, you should be informed. At the very least, you need to know in enough time to make the payment yourself — before your credit is impacted.
However, your best policy might just be to find some other way to help rather than co-sign. Co-signing a loan is a serious commitment, and it can have very real financial effects.