Lingering unemployment has made it difficult for many people to get credit. That can put you in a tough spot if you're the parent, sibling, close friend or relative of someone who hasn't been able to land a good paying job. What do you do when their car breaks down and they need to buy a replacement and can't qualify for a loan? Should you agree to be a co-signer on that loan?
It's difficult to deny the people you love anything, especially when they truly need something. So you may decide that being a co-signer with them on a credit card or a car loan is something that you want to do. But you need to fully understand what being a co-signer means—and how it could have a negative impact on your own credit score in the years ahead.
As a co-signer, you take on the responsibility for a debt if the primary signer fails to fulfill the terms of the credit or loan agreement. The Federal Trade Commission advises consumers considering co-signing to “think about the obligations involved and how they may affect your own finances and creditworthiness. When you agree to co-sign a loan, you’re taking a risk a lender won’t take.”
If the primary borrower fails to make payments, the bank or the credit card company is going to come after you for the money they’re owed—and that could include late fees or collection costs if the creditor has sent the bill to an agency. If you’ve put up personal property or your home as collateral for the loan, you could lose them if you can’t make those payments.
Do an honest appraisal of your own finances to determine if you’re able to take that risk. Would making those payments put your own budget way out of whack so that it’s hard for you to manage your other bills?
Since your name is on the loan or the account as a responsible party, the payment history on that account will show up on your credit history. Even one late or missed payment can have a negative impact. FICO, the company that calculates the most widely used type of credit score, says that about 35 percent of your credit score comes from your payment history. So when you cosign, you’re putting your good credit record at risk of being ruined by someone else’s poor money habits.
Suppose you co-sign for a new car loan for your daughter and then a month later your own car gives out and you have to replace it. You could have trouble getting a loan, or may have to pay a higher rate of interest than you would have before you became a co-signer.
Banks like to see a debt-to-income ratio of around 30-35 percent. That’s the amount of money you owe versus the amount of money you bring in each month. Get any higher than that, and they’ll start to consider you a bigger risk—and charge you a higher interest rate.
When you cosign for a loan or a credit card, the card limit or the amount of your loan gets counted against your debt-to-income ratio. Remember, you’re on the hook if the primary borrower defaults.
It’s time to have a serious talk with the borrower. Ask about their current finances—how do they intend to keep up with their regular bills while making these new payments? Will they consider replacing this loan with another (in their name only) if their financial position improves? Can they get a second job to ensure that they’ll be able to make payments?
Remember, when you co-sign for a loan or a credit card it’s not only their financial future at stake—it’s yours as well.