Loans allow you to borrow money for an expense that you can’t pay in full and pay it back over time. Many people take out loans for large purchases, like a car or home. Others take out loans to transfer the balance of an existing loan to one with a lower interest rate so they can pay it off sooner.
Regardless of the purpose of the loan, in certain circumstances, borrowers may be asked to take out a cosigned loan. What is a cosigned loan? Read on to learn more about these loans and what you should know before cosigning.
What is a Cosigned Loan?
If someone wants to take out a loan, but they have a low credit score or a short credit history, a credit union or bank may not lend to that person if they’re the only one signing for the loan. Financial institutions want reassurance that the loan will be repaid. A cosigned loan may provide that assurance.
A cosigner is one who agrees to pay the debt if the primary borrower defaults. This means that if the primary borrower doesn’t make their payments, the cosigner becomes responsible for making the payments. This can allow those who are denied a loan based on their own credit to borrow the money they’re requesting, because the bank or credit union now has a guarantee from a more established borrower that the payments will be made.
Before You Cosign a Loan
If you’re asked to cosign a loan, there are many things to consider. First of all, make sure your own finances are in good shape. You don’t want to cosign if you’re struggling to pay your bills, in the middle of a career transition, planning for your own large purchase, or close to retirement.
You also want to make sure the person you cosign for has their own financial situation under control. You may feel differently cosigning for a child who is responsible, but can’t get approved for a loan on their own because they have newly established credit, versus cosigning for someone who has a history of making late payments or taking on too much debt.
In either case, while it may feel good to help someone out, neither of you will benefit if the primary applicant defaults. Talk to them about the plan they have for making payments and ensure you feel comfortable with how they spend their money before cosigning for them. Also, make sure that you have the financial resources available to make the payments, and are willing to do so, if they can’t.
Pros and Cons of Cosigning a Loan
Should you cosign a loan for someone else? A lot of factors play into your decision. We’ve compiled a few considerations below.
Pros of Cosigning a Loan
There can be advantages to cosigning for someone else’s loan. Here are a few examples.
- You’ll help someone in need. A relative, such as a child or grandchild, may ask you to cosign a loan. You may want to assist them because you believe in them and want to help them reach their goals after high school or college.
- You may help someone establish good credit. The borrower may be able to build their credit as a result of your assistance. As long as the payments are made on time, they may see a positive impact on their own credit, allowing them to get financing independently in the future.
Cons of Cosigning a Loan
There are many risks associated with cosigning a loan. Here are a few disadvantages to cosigning for someone else’s loan.
- If the borrower doesn’t repay the loan, you’ll be held responsible for repaying it. You can ask the borrower if they’re making their payments, but you may not know for sure until the financial institution alerts you of a default. Then, you’ll be required to take over repayment, which could be a significant financial burden.
- You can’t get out of a loan that you cosigned. When you cosign a loan, you’re making a commitment. Your responsibilities are only lifted if the loan is repaid or the primary applicant refinances on their own after re-qualifying to take out a loan by themselves.
- Your credit may be impacted negatively. If the primary applicant does not make timely payments or defaults on the loan, your credit may be negatively affected.
- You could limit your ability to get a loan in your name. The debt for the cosigned loan will raise your debt-to-income ratio. Even though you may not be making loan payments now, this debt is counted against you when financial institutions assess your income. Depending on your financial situation, your ability to secure a loan may be impacted.
Financial institutions look for someone whose history exhibits financial responsibility. Here are a couple of requirements to be a cosigner.
- You must have good credit. You’ll want to check with your bank or credit union to determine their specific requirements.
- You must show evidence that, if the primary borrower defaults on their loan, you have the financial means to repay it. You may have to show pay statements or tax returns.
Cosigning a loan is an important decision and something you should consider carefully. While you want to help someone in need, you need to balance the practical implications of taking on this responsibility.
For more insights on financial decisions, visit our WalletWorks page.