How Cosigning a Loan Can Affect Your Credit
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Cosigning a loan can have a big impact on your credit score. When you cosign for a loan, you assume equal responsibility for repaying the debt. If the primary borrower is unable to repay the loan, then the lender will expect the cosigner to repay the loan.
It is important to realize that if you cosign for a loan, you assume the risk of a loan with minimal benefits.
Can cosigning a loan affect your credit?
Cosigning for a loan can potentially hurt your credit with few rewards to offset this risk. The primary borrower will receive a boost to their loan application and the use of the funds. However, the cosigner is unable to use the loan for their own purposes and leaves their own credit in a vulnerable position.
Let’s take a closer look at how your credit can be affected by cosigning a loan.
Equal responsibility for the loan. When you agree to cosign a loan, you are agreeing to pay off the loan if the primary borrower cannot pay it back. If a primary borrower requires a cosigner, then they likely have a poor credit history or a very short credit history. In either scenario, you are trusting that the primary borrower will repay the loan. If they don’t, then you will be on the hook for the outstanding amount. “Once you’ve cosigned on a loan, that loan will appear on your credit report and affect your credit score just as though you were the primary borrower,” said Logan Allec, a certified public accountant in Los Angeles. Every negative and positive move of the loan repayment process by the primary borrower could affect your credit.
Credit utilization rate. Credit utilization, a ratio comparing how much credit you use with how much you have available, accounts for 30% of your credit score. As credit utilization increases, your credit score may experience a drop. When you cosign a loan, you are increasing your credit utilization rate. Experts recommend keeping your total credit utilization score below 30% in order to maintain a good credit score.
Debt-to-income ratio. Cosigning on a loan effectively makes you responsible for the entire loan amount if the primary borrower stops making payments for any reason. Because you are ultimately responsible for the amount of the loan, it will affect your debt-to-income (DTI) ratio. Your DTI is a ratio that compares the total amount of debt you are required to repay each month to the amount you earn each month. For example, if you have monthly debt payments of $1,000 and your monthly income is $5,000, then your DTI is 20%. Typically, lenders prefer DTI ratios of 36% or less. When you add the loan amount you have cosigned for, your DTI could increase significantly.
Late payments. As the cosigner, you will need to ensure that complete payments are made on time. Otherwise, each missed payment could put a negative mark on your credit history. “Any late payments, missed payments or defaults will appear on your credit score, and the effect could be extremely negative,” Allec warns. It can be difficult to keep track of the primary borrower’s payments because the bills will not come directly to you. However, it is vital that you keep track of the loan. The lender will typically not keep you informed on the status of the loan unless you sign up for regular updates. Make sure to sign up for any means of communication about the loan such as text or email alerts. Stay up to date about the status of the loan and communicate with the primary borrower about the loan on a regular basis. If the primary borrower misses payments, your credit score could suffer.
Permanent commitment. When you cosign on a loan, you are making a permanent choice. If your relationship with the primary borrower gets rocky or ends completely, you are still legally responsible for the loan. Needless to say, this can be detrimental to your credit. The cosigner trusts that the borrower can repay the loan without any assistance. However, not every primary borrower is able to repay the loan. If they default on the loan, the lender will expect you to pay off the loan. It is possible that your financial situation will change from the time you cosign a loan to when the primary borrower defaults. If you are unable to repay the loan, you may be stuck in a lawsuit with the lender and incur a large dent in your credit history.
Benefits of cosigning a loan
One way that cosigning a loan could benefit your credit is by enhancing your credit mix. Your credit mix is determined by the types of loans in your credit history. This factor can account for 10% of your overall credit score. If your credit history is mostly composed of credit cards, then cosigning on an auto loan could increase the diversity of your credit mix and lead to an increased credit score. Although your credit mix is a small percentage of your overall score, a strategic cosigned loan could potentially affect your credit in a positive way.
The more obvious benefit of cosigning on a loan is that you are able to help out a family member or close friend. If a loved one is unable to obtain approval for a loan without a cosigner, they may ask for your assistance. Helping a loved one obtain a loan — providing them an opportunity to build credit in the process — is a noble and worthwhile endeavor.
The bottom line
It is important to consider whether you can afford the financial responsibility before cosigning on a loan. Remember, you are equally responsible for the loan. So if something goes wrong for the primary borrower, then you will need to step in and make the payments.
Beyond the potential negative impacts on your credit, think about your long-term relationship with the primary borrower. Defaulted loans can end in a broken relationship. Is this loan worth risking that? Consider helping them to find the best credit repair resources instead of cosigning on their loan.
In sum, you may want to help out your friend or family member, but you should proceed with caution. Consider the financial situation of the primary borrower and your own ability to repay the loan before agreeing to cosign.