It can be rather tempting to agree to cosign a personal loan when a friend, family member, coworker or roommate asks for your help. The problem, though, is cosigning a loan carries a lot more weight than just letting someone use your name to get approval for something they currently can’t afford.
While there are some instances where cosigning goes well, there are countless instances where everything does not work out as planned. What may seem like a quick favor could turn into financial troubles for you for months or years to come.
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What happens when you cosign a loan
When someone applies for a loan, the lender looks at that person’s financial picture, credit score, history and overall creditworthiness to determine if they can be approved for the loan. When they don’t meet the minimum requirements, the lender agrees to approve the loan if they can find someone else with a stronger credit profile to agree to share responsibility for the loan. This is called cosigning.
While this might seem like nothing more than a strong recommendation or favor of support, it is much more than that. When you cosign a loan, you are effectively taking equal responsibility for the loan. This means that if your friend or family member stop making payments, you are now liable for the loan. Your friend is not 90% responsible and you’re 10% responsible. You are both 100% responsible for the loan and all of the associated terms.
Reasons to not cosign a loan
Have you been approached recently to “do a quick favor” for a friend or family member by cosigning on a loan? Here are five reasons why you may want to rethink agreeing to go out on a limb, especially if it’s a strong, close relationship.
1. The lender says they are too risky.
The biggest reason not to cosign a loan should be that the experts with complete information determined your friend or family member was too risky to extend a loan to. Lenders have access to credit reports, banking statements and a full view of your friend or family member’s financial picture.
Lenders are experts at knowing who is and who is not likely to default on a loan. If after seeing all of your friends or family member’s information (that you don’t have access to), they decided it was too risky, there is no reason that you should feel any differently. Emotions can convince you otherwise, but smart fiscal decisions are not rooted in emotions; they’re based on facts.
2. You could ruin your own credit.
Not only would your friend or family member’s credit be negatively impacted or ruined by defaulting on the loan, but yours would as well. Remember, your credit score shows more than just your ability to pay bills on time; it shows your ability to make financial smart financial commitments you can stick to.
“On top of the fact that you are ultimately held responsible for paying off the loan, your credit score and ability to take out a loan for yourself could potentially be impacted. If the person you cosign for misses a payment or defaults on the loan, your credit score could be severely negatively impacted,” says Laura Morganelli, certified financial planner with Abacus Wealth Partners. “Additionally, cosigning a loan increases your debt-to-income ratio. Debt-to-income ratio is what many lenders use to determine if you are eligible to take out a loan and what the terms of the loan might be.”
When you agree to cosign a loan, you say that you’re 100% sure your friend or family member will pay back the loan, and if not, you will step in and pick up the slack. Failure to do so would not demonstrate financial reliability to the credit reporting bureaus.
3. It’s high-risk and low-reward
You may be picking up on a trend thus far; cosigning a loan may be great for the other party, but for you, it’s a lot of risk for little to no reward. A basic principle of sound financial decisions is making choices that carry a balanced risk and reward profile. If you’re taking on a lot of additional risks, you should at least have the potential to make the same or more in rewards. When you make decisions that are upside down on risk (too much risk for not enough reward), you set yourself up for failure.
4. Relationships can be ruined.
You are rarely going to be asked to cosign a loan by someone who is not close to you. In most instances, it’s a family member, coworker, close friend or neighbor. Sure, they may be grateful when you agree to cosign the loan because it allows them to get the funding they are looking for.
But what happens when they start to miss payments or their financial picture changes, and they can’t keep up with the loan? How are they going to handle the tough discussions when you have to demand they pay? Cosigning a loan exposes your relationship to a lot of risk for short- and long-term damage if everything does not go to plan.
5. You may find yourself involved in lawsuits.
If the other party on the loan defaults, the lender may have no other form of recourse but to sue for their funds. The problem, though, is that there’s a strong likelihood they will sue you first. As the other party has already defaulted on the loan, it is much more likely that you’ll have the funds they can get to cover the rest of the loan. While this might not be fair, the lenders just want to get paid and will do whatever is necessary to make that happen. Unfortunately, the company does not pay its employees and investors with goodwill and charity.
Following this, your only recourse to get your money back could be to sue the person whose loan you cosigned. This can be severely taxing on relationships and get expensive. These are both undesired outcomes, but it may be inevitable when things go sour.
Check Your Personal Loan Rates
Answer a few questions to see which personal loans you pre-qualify for. The process is quick and easy, and it will not impact your credit score.
The bottom line
There may be some rare occasions where cosigning a loan for someone close to you is a smart move. However, you need to be aware of the risks you’re taking on and the lack of rewards in return. Understand that as the cosigner, you are equally responsible and liable for the loan in the eyes of the law. If your friend, family member, neighbor or coworker defaults and stops making payments, you’re on the hook for the remaining balance.
The post 5 Reasons to Not Cosign a Loan appeared first on The Simple Dollar.
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