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Before agreeing to cosign on a car loan, it’s important to understand the risks.
Doing the favor of cosigning on someone’s auto loan can help them qualify for the car they want — but whether you should cosign isn’t a decision to make lightly.
As a cosigner, you’re responsible for their debt, and your credit could take a hit if they don’t pay. This post discusses how cosigning affects your credit and other implications of cosigning to be aware of before signing on the dotted line.
What Does It Mean to Cosign on a Loan?
Cosigning on a loan means you guarantee repayment of a borrower’s debt if they don’t pay. When someone has no credit or poor credit, adding a cosigner with good credit to their loan reduces the risk for the lender, which can help them get approved.
It’s common for young adults without a credit history to need a cosigner to qualify for their first few loans. However, a close friend, loved one, or acquaintance with bad credit could also ask you to cosign for them if they’re having trouble getting an affordable loan. With you on the loan application, they could land a lower interest rate and better monthly payment.
Can Cosigning Affect Your Credit?
Cosigning on a loan can affect your credit positively or negatively depending on how the debt is managed. Here’s a rundown on the good and bad of cosigning.
Ways cosigning could positively affect your credit
The loans you cosign for show up on your credit report if the lender reports payments to the credit bureaus. If the loan is paid on time, on-time payments could help you build credit and improve your credit score.
Adding a car loan to your credit report could also diversify the types of credit accounts you have, and that can be good for your credit mix. Having a mixture of account types on your report shows you have experience managing different forms of credit and this can help your score.
Ways cosigning can negatively affect your credit
Despite the potential positives, cosigning is risky because there’s no way to guarantee a borrower will pay the loan back. Let’s say the borrower loses their job or can’t pay for another reason. Here’s how that might affect your credit.
- Late loan payments can give you poor credit history. If a payment on a loan you cosign for is late, it can show up on your credit report and dock your score. The number of score points you’ll lose from late or missed payments can vary. According to FICO, the cleaner your credit profile is, the more points you stand to lose from late payments.
- Debt collectors could call you for payment when the borrower defaults. If loans you cosign for end up in collections, it can have a severe effect on your score. Debt collectors might also ask you to pay the loan amount in full, and that can cause financial strain.
- A car repossession can show up on your credit report. Cars can get repossessed if payments aren’t made. This can also show up on your credit report and have a devastating effect on your credit history and score.
- You could get sued for unpaid balances. If a debt collector isn’t able to collect a balance due from you or the borrower, you could get sued for it. And if the court judgment isn’t in your favor, your wages could be garnished to repay the debt.
- Poor credit history can make lenders less willing to lend to you. When it’s time to open a new credit card or borrow money for your own car or home, poor credit history on a loan you cosigned for could make it harder to get approved.
Also, note that late payments and collections accounts can stay on your credit report for up to seven years. So, it could take a while to bounce back from the damage cosigning can do. That’s why it’s important to only cosign for borrowers you feel confident will keep up with payments.
Other Financial Implications of Cosigning
Besides the effect on your credit, cosigning can have other drawbacks. One main one is that cosigning increases your debt load. Even if the loan is paid on time, being responsible for someone’s debt can make it harder to qualify for a loan when you want to buy a home or car.
Loans you cosign for can increase your debt-to-income ratio (DTI), which is a factor lenders review when approving you for a new loan. You can calculate DTI by totaling your monthly debt payments (including the loan you cosign for), dividing that total by your gross monthly income, and multiplying by 100. The calculator below can also help you do the math.
(DTI) Debt-to-Income Ratio Calculator
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The maximum DTI you can have to buy a house depends on the type of home loan you’re applying for. In general, lenders look for a DTI below 43%, but you could get approved with a higher percentage in some cases. For a car, many lenders accept a DTI of up to 50%. But like with home loans, some auto loan lenders might approve a larger percentage, as well.
If you have a few big-ticket purchases planned, it could make sense to focus on your personal finance goals first before doing the favor of cosigning.
Another financial pitfall of cosigning is that you might need to come up with a solution to pay off their debt if they can’t, which could be hard on your budget. Plus, arguments about money when the borrower isn’t paying can put a strain on a relationship with family or friends.
How To Minimize Issues When You Cosign
If you’re considering cosigning on a loan, here are some ways to prepare and minimize the negative fallout:
- Only cosign for someone you trust. You should feel confident that the person you cosign for will keep up with payments. Is their income unstable? Have they had trouble managing credit cards or loans in the past? If the answer to either of those questions is yes, cosigning on their loan might not be a good idea.
- Double-check your budget. Before cosigning, consider whether you have the financial flexibility to pay off the loan. In the worst-case scenario, you might be responsible for paying the debt, and you want to make sure that won’t put you in a financial bind.
- Review the contract. Ensure you’re comfortable with the loan terms before signing and understand your responsibilities as the cosigner.
- Stay in the loop. After the deal is sealed, keep in contact with the person you cosign for to confirm they’re able to make payment. If they’re unable to, you could offer to make payments temporarily to protect your credit if they’re experiencing financial hardship.
How To Remove Yourself as a Cosigner
Removing yourself as a cosigner isn’t always possible. But in some cases, lenders offer a cosigner release option that removes you from a loan after certain conditions are met. This loan feature may be available on a case-by-case basis, so you’ll have to discuss it with your lender.
If the primary borrower’s credit improves after borrowing, asking them to refinance the car loan is another way to remove yourself from the situation. Refinancing is taking out a new loan to pay off the old loan, and you would no longer be financially responsible for their new loan.
Should You Cosign on a Car Loan?
Whether or not to cosign on a loan is a personal decision. The general consensus among financial experts is to avoid cosigning on loans because the potential risks are high.
However, in some cases, cosigning a loan could make sense. If you financially support a young adult or dependant, cosigning on their car loan and helping them make payments could give them a headstart in building credit. After establishing a positive payment history, they could be able to apply for their next car or first home on their own.
A potential red flag to look out for is a long-lost family member or someone who seems to always be in financial trouble asking you to cosign on a loan. While it can be hard to say no, it’s important to protect yourself. Think of it this way — losing financial stability because you cosigned on someone’s loan could jeopardize your ability to provide for your own family. When put into perspective, it might be easier to make a decision for or against cosigning.