Protect Yourself: Approach Co-signing With Caution

Co-signing a loan for a family member or a friend can be a kind-hearted gesture, but it involves substantial risks that should not be ignored. Whether it’s for a child’s car loan, a student loan, or a friend’s business venture, it’s important to understand all the possible drawbacks before agreeing to co-sign. To avoid any potential financial trouble, here’s what you need to know:

Your Relationship May Change  

Lending money to someone you know and care about can alter the dynamics of the relationship, regardless of whether they pay back the loan as agreed. This is often the case, especially if there is a default.

Why? It could be due to the change in power dynamics between the lender and borrower, particularly when the two parties already have an existing relationship. At any rate, consider your relationship carefully before you decide to co-sign a loan.

Co-signing a Loan and High-risk Lending  

It is important to keep in mind that if a borrower is unable to obtain a conventional loan from a bank, mortgage company, auto lender, or credit card company, then they have been evaluated to be a high-risk borrower. This means that professional lenders have determined that the borrower is more likely to default on their loan.

In my experience, mainstream lenders are usually pretty good at assessing risk, and if they are unwilling to offer a loan, it is advisable for you also to exercise caution. If the borrower defaults on the loan, you will ultimately be held responsible for repaying the debt.

Being a Co-signer Could Impact Your Credit  

Depending on how the lender reports to the credit bureaus, the payment history for the co-signed loan may show up on your personal credit history. Late payments or defaults on the co-signed loan could negatively impact your credit score.

Your Ability to Borrow Could be Restricted  

If you decide to be a co-signer for someone’s loan, keep in mind that it may affect your chances of getting your own. This is especially true for bank loans because you will be required to submit a financial statement listing your assets and liabilities. While the co-signed loan is not directly your responsibility, it is still considered a ‘contingent’ liability, meaning the bank will consider that it could become your direct responsibility at some point in the future. For example, if you co-sign a $250,000 business loan for your adult child, you would need to list it as a contingent liability on the financial statement you submit to the bank. 

Additionally, lenders will take both your credit history and debt ratio into consideration before granting you a loan. As mentioned, in the case of defaults or late payments, co-signing can have negative impacts on your credit history, which will be taken into account by the lender. Further, the amount of the co-signed loan will affect your debt ratio, one of the key metrics lenders use to evaluate loan approvals.

Conclusion

While there may be scenarios where co-signing is unavoidable or deemed necessary, it’s generally advisable to avoid it whenever possible. If you do decide to co-sign, take steps to protect yourself. Request online access to the account and ensure the lender notifies you immediately of any missed payments, allowing you to address issues promptly.

By understanding the risks involved and taking proactive measures to mitigate them, you can make more informed decisions when it comes to co-signing loans, safeguarding your financial well-being, and preserving your relationships.

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