If you are new to the concept of cosigning a loan, you might be wondering why someone would ask to add you to his or her loan application. Typically, the main reason is for the primary borrower to successfully obtain a loan. Given the realities of credit and loan rejections, it’s becoming more difficult to take out a loan without a strong credit history and an excellent credit score. Ironically, the trick to building that very history is establishing new credit lines. This puts many young people at a disadvantage because even though they are financially responsible, they cannot yet demonstrate a strong history of credit.
One instance of why someone may need a cosigner is simply because they don’t have a sufficient credit score, which then hinders their ability to qualify for a loan. Since lenders are in the business of originating responsible loans, they want to lend funds to those people who are most likely to repay their obligation with interest. If the lender views the borrower as unable to repay, bringing on a cosigner can provide the lender assurance about the ability to satisfy the debt. The greater this assurance, the lower the interest rate associated with the loan. This means that someone with a weak credit score can generally receive a lower payment quote on his or her car lease by adding a creditworthy cosigner to the loan application.
But not everyone who brings on a cosigner does so because of a low credit score. Some borrowers may simply have maxed out their credit lines, and cannot open any new ones without the help of another creditworthy individual. These borrowers typically carry a higher debt-to-income ratio, or DTI, and are often viewed by lenders as a greater risk for default. Adding a cosigner can help those individuals open a new credit line during a financial emergency such as a job loss or an unexpected medical bill.
Whether you find cosigning a risky practice or a tool to help a trusted friend in need, there are some situations when stepping in as a cosigner can have a positive influence on the primary borrower:
- Amy, 23 who hasn’t yet developed her credit history, asks her dad to cosign a new car lease. The monthly payment would have been substantially higher without a cosigner who backed the loan using their excellent credit and personal assets.
- Mary 49, cosigns her son Mark’s student loan to cover tuition costs. Without his mom’s guarantee, Mark would not have been able to continue to attend college and finish his degree.
- Dee, 33, an inspiring entrepreneur plans to open a new bakery in his hometown and asks his brother to cosign a personal loan for his new business.
- Chris, 44, found a great investment opportunity for a rental property. Since his debt-to-income ratio is too high for a second home, he asks his brother to cosign the new mortgage. After closing, Chris is able to successfully place new tenants and starts making rental income each month.
As these examples illustrate, cosigning a loan is not always a bad idea. If you trust the primary borrower, there are a few sound reasons to cosign a loan:
Opens the Door to New Financing Opportunities
As anyone who has tried to obtain financing lately knows, lenders look for several components such as credit score, income, expenses, and collateral when qualifying borrowers for a loan. If any one of those criteria is unsatisfactory, you might see a big red rejection stamp on your application. Taking on a cosigner can simply open up your ability to even get a loan. Lenders will gladly reconsider a rejected application if there is a cosigner attached to it. This could open the doors to purchasing a new home, starting up a business or leasing a vehicle.
Potential to Secure a More Attractive Loan Rate
Since qualifying for a loan requires the borrower to meet a certain set of criteria, even the slightest “stain” on your credit history could be seen as a red flag. For example, you may have experienced financial difficulty a few years back, but have since paid off your debts. Even though you are financially stable today and capable of sustaining a new loan, the lender may still question your history and quote you a slightly higher rate to compensate for the perceived risk. This is where the cosigner comes in. With a second person guaranteeing the loan, and thus reducing the risk, the lender would most likely be able to decrease the interest rate. Using this strategy can save the primary borrower thousands of dollars over the life of the loan.
Helps Applicant Build Credit
How to build credit when you have none? By using a cosigner. If you have a trusted friend or relative with excellent credit, you may want to ask them to cosign a new loan application for you. Anyone who is looking to build or repair credit can leverage a cosigner to set an impeccable credit score in their future.
What You Should Know Before Cosigning a Loan?
It’s no news that cosigning a loan only provides a benefit to the primary borrower. Unless you consider helping out a family member a good deed, there are no financial benefits to cosigning a loan for someone else. By cosigning, you are fully liable for the loan without actually benefiting from the money.
However, if for one reason or another, you do agree to help a loved one, make sure to consider the following drawbacks:
- Reduced Borrowing Ability - One important indicator that lenders use to assess your ability to borrow money is your debt-to-income ratio, or DTI. When you cosign a loan for someone else, your debt-to-income ratio will always go up. Generally, lenders view consumers with higher DTI ratios as riskier borrowers because they might run into trouble repaying their loan in the event of financial hardships. Therefore, cosigning a loan for someone could make it harder to qualify for a mortgage or an auto loan, despite the fact that you are technically not making any payments on the loan you cosigned for.
- Jeopardizing Your Relationship - According to Princeton Survey Research International Associated, a poll of 2,003 U.S. adults concluded that 38 percent of cosigners were forced to pay all or a part of a loan, with 28 percent suffering a drop in their credit score as a result of the primary signer’s late payment or default. More than a quarter said their relationship with the signer suffered as a result of this arrangement. If you feel that your relationship may be affected, it’s best to reconsider cosigning the loan to avoid the complexities of mixing family, friends and money. Your best bet may be to suggest the person defer on their purchase requiring the loan and instead focus on building their credit profile. This way, they might get the loan they want without adding you to the application.
Managing Risks Associated with Cosigning
Know Your Borrower
Unless the person is a family member or a very close friend, becoming a cosigner can be risky business. If they happen to default on the loan, you would still be stuck with all liability for their debt. This could not only lower your credit score but jeopardize your personal assets. It can be difficult to remove a cosigner from a loan, so make sure you know and trust this person before agreeing to anything.
Review Your Budget
It’s important to evaluate your ability to pay the loan if the borrower defaults. You might think that it’s not a huge deal now since they will be the ones making payments, but if they are not able to make the payments, you need to feel comfortable enough to step in and cover them.
Get Copies of All Documents
Don’t assume the primary borrower is making payments to the loan. Oftentimes, it could be months or even years before the consigner finds out about any delinquencies or that the primary borrower has stopped paying entirely. By that time it could be too late because your credit will already have lowered. It’s always a good idea to set up notifications for any late payments, or better yet, gain access to log into the loan account to monitor status.
Ask for a Release
When you cosign a loan, some lenders give you the option to release your obligation. The release essentially allows you to remove your name from the loan after a certain number of payments have been made. Since the release is typically not automatic, it’s a great idea to ask the lender whether this is a viable option.
Before committing to any financial commitment, it is always wise to seek the advice and support of a professional – such a financial advisor, attorney or a mortgage professional if it’s home loan related. So, if the situation arises and you need help deciding whether co-signing is the right choice for you – don’t hesitate to contact us.