What to Know Before Co-Signing a Loan

We all love our kids, right? Sometimes the trick is knowing the best ways to show that love. And for the kids, it’s important to recognize that your parents are generally trying to do what’s best.

That’s what co-signing a loan is like, whether asking someone to co-sign or deciding whether to co-sign. There are times it can be the right solution to help a child or other family member accomplish a goal. And there are times when everyone would be better off if you simply said no.

Say graduation is approaching and your pride and joy asks a favor: Please co-sign a $25,000 car loan. There are good arguments in favor of the idea. A reliable new car will help with every aspect of starting out as a young adult. Transportation for a new job. Independence, which also benefits mom and dad, right?

If you have unlimited resources, it’s a no-brainer. Most of us don’t have that luxury. So the favor isn’t as simple as it might sound. If co-signing the loan is a mistake, it could hurt the parents as well as their pride and joy. The parents get stuck with a debt obligation (on top of what they’ve already paid for college, etc.) and the child may get off to a poor start building a healthy credit profile.

In short, co-signing a loan comes with risk.

How Does Co-Signing Affect My Credit?

The moment you co-sign a loan, that loan and its ensuing payment history become a part of your credit history, as well your child’s or other family member’s. When the lender performs a hard credit check as part of the loan process, your credit score will temporarily drop by a few points. This can affect your ability to obtain other credit.

That is risky, but it gets even more risky. A missed payment (or payments) by the primary borrower can negatively affect your credit score as well. You have agreed to share responsibility for this loan (while receiving no boost to your credit score if the loan is repaid). Payment history, which you have tried to keep current your whole life, has the biggest impact on credit scores. A misstep on a co-signed loan can ruin your credit.

Can I Remove Myself as a Co-Signer From a Loan?

You may feel the need to pull the rip cord, but that doesn’t mean the parachute will open. Not all lenders allow a co-signer to be released from a loan. If your lender does, that may require a credit check to ensure that the main borrower (your pride and joy!) is capable of making payments on their own.

Be sure to understand the terms for removing yourself from the loan before you sign anything.

Reasons You Shouldn’t Co-Sign

Research International Associates conducted a poll of 2,003 U.S. adults in early 2016 that found that 38% of co-signers were forced to pay all or part of a loan. Twenty-eight percent of the co-signers suffered a drop in their credit score as a result of the primary signer’s late payment or default. And more than a quarter said their relationship with the signer suffered as a result of the arrangement.

Even if the borrower makes payments, the fact that your name is on a debt can impact your credit score. The debt shows up on your credit report, and the use of credit counts for 30 percent of your score. Having your name on a co-signed loan also increases your debt-to-income ratio because you are liable for the loan once you sign it. That, in turn, can make it harder for you to borrow for yourself if you need to.

This, surprisingly, doesn’t stop people from co-signing loans. The Princeton Survey poll found that one in six American adults have co-signed a loan. Typically, they are older than 50 and are co-signing a car loan for a child or close family member.

There also could be tax consequences for co-signing a loan. If the borrower can’t pay the loan and convinces the lender to accept a settlement, the Internal Revenue Service won’t count the forgiven debt as your income. For example, if the borrower racked up $15,000 in credit card debt that you co-signed for and the lender accepted a settlement for $7,500, the borrower might have to treat the forgiven $7,500 as income. But if you never used the credit card or benefitted from purchases made with it, you wouldn’t have to pay tax on the forgiven money yourself. Recognizing your unique role in the debt, the IRS considers you a guarantor and not a debtor.

You also might be entitled to deduct interest paid on a co-signed loan in certain cases. For example, the parent of a student who is making payments on a student loan can deduct the interest if the parent claims the student as a dependent. If the student isn’t claimed as a dependent, the parent can’t deduct the interest even if the parent pays it.

Finally, there is a risk of conflict within a family or other relationship. This is true of most financial dealings with familiar people. Take care to keep the business aspect separate from the personal relationship.

More Than 30 Percent of Co-Signers Get Stuck With Debt

Surveys suggest that more than a third of loan co-signers are stuck with the debt when the primary borrower stops paying. When one party to a co-signed loan defaults, the other is responsible for the balance.

It gets worse. If you co-sign a loan and the other party dies, it becomes your debt. If you have assets and the person you cosigned for doesn’t, the lender probably will sue you first if the loan goes into default.

It might be hard to say no to a family member, significant other or close friend who asks for you to co-sign. They’ll tell you how much they need whatever it is they want to buy and that they won’t let you down.

But remember, whether it’s for a lease, a mortgage, a credit card, or a student or car loan, co-signing is essentially risk without reward. Your co-signature obviously helps the person get a loan, and lenders are more than happy to bring you into the deal if they believe your assets safeguard the money they loaned.

If 30% of co-signers wind up in debt, that means a majority of co-signers, some 70%, do not suffer that fate. That is significant. Laying out the pros and cons of a financial decision shouldn’t just be a list of the cons.

You can improve your chances of winding up on the positive side. Consider the credit history and reliability of the person asking you to co-sign. If you offspring isn’t quite ready to qualify as a good risk, you may choose to wait until their prospects improve before co-signing a loan. You may also help them to improve their credit scores or arrange a side agreement that gradually shifts the responsibility from the co-signer to the main borrower.

Another tip: Base your decision on the same logic you would base asking for a loan of your own. Co-signing for a student loan or a house down payment may be more appropriate than helping buy a pricy sports car or invest in a start-up business that doesn’t look like a good idea.

Reasons for Possibly Co-Signing

Before considering co-signing a loan, make sure you’re capable of repaying the loan if the primary borrower defaults. Perhaps a better idea is giving the friend or family member a personal loan for part of what they need. Perhaps a lender is willing to loan no more than 50 percent of what is needed to buy a boat. You could loan the remainder necessary, enabling the borrower to make the purchase, but avoiding the risks associated with co-signing.

You could try convincing the would-be borrower to defer the purchase requiring a loan, then working with them to improve their credit score. You might also encourage them to supplement their income with part-time employment, giving them more borrowing power. In this case, they might get the loan they want and you can stay off the loan application.

Finally, if you co-sign a child’s or relative’s private student loan – a very common practice – make sure you look for loans that come with a co-signer release. Releases generally release the co-signer from liability after a certain number of payments have been made on the loan. If the student loan has a release clause, the co-signer should file for release as soon as possible.

This step not only benefits the co-signer but the borrower. The Consumer Financial Protection Bureau has warned that some private student loans will automatically go into default if the co-signer dies or becomes bankrupt, even if payments are made on time. Releasing the co-signer safeguards against that happening.

A Co-Signing Checklist

Things to consider before you decide to co-sign a loan:

• Can you afford it. You will guarantee someone else’s debt, make sure you have the money to spare if the debtor defaults.
• A default on the debt, even if you have nothing to do with it, becomes your problem. It can damage your credit and subject you to debt collectors. You could be sued if debt payments aren’t made, and the creditor might come after you before turning to the borrower.
• Ask the creditor to calculate what you might owe if the loan goes into default. Try to negotiate the terms of the loan to limit your liability, excluding things like attorneys’ fees and court costs. Have those provision included in the loan documents.
• Ask the creditor to contact you if the borrower ever misses a payment.
• Get your own copies over all loan documents, including truth in lending forms and disclosures.
• Check what rights your state affords co-signers.

Frequently Asked Questions About Co-signing