Why Co-Signing Loans Can Hurt Your Credit

Co-signing a loan might feel like a good way to help a friend or relative, but there are real financial and emotional implications. When you agree to co-sign a loan, you are now legally liable for that loan if the borrower defaults. All it takes is one missed payment for your credit score to drop, your debt-to-income ratio to jump, and your ability to qualify for credit to decrease. That’s why co-signing loans can hurt your credit.

The effects are not just financial; even a one-time missed payment can be detrimental to your relationship. It is much easier to build resentment or feel betrayed if the loan is not paid; therefore, it is important to fully understand the co-signer’s responsibilities and risks before signing. 

When you fully understand the consequences, it will help you decide whether to support someone’s need for credit without compromising your credit status or financial well-being. You can aid an individual in a way that benefits your credit and your goals for building assets over time by properly structuring the loan, tracking it, and verifying loan options that still provide some support to the individual.

What Does It Mean to Co-Sign a Loan

Co-signing a loan is a legally binding commitment to someone else’s debt, which means you take responsibility if they do not pay back the loan. It is important to understand the duties and process of co-signing a loan to protect yourself from unanticipated problems.

Definition

A co-signer is an individual who legally commits to being jointly responsible for the loan with the original borrower. If the borrower does not make payments, the co-signer must pay off the original borrower’s debt. Although a co-signer gives lenders confidence to make loans, the co-signer assumes the financial risk.

Co-Signing Process

A lender will often require a co-signer when the borrower has little or bad credit history. By co-signing, the co-signer assumes the responsibility of ensuring the borrower will pay. This means the borrower might qualify for credit they would not ordinarily qualify for. This kind of agreement requires careful monitoring of payments.

Legal Obligation

Becoming a co-signer creates a legal obligation. If the borrower does not pay, the lender can pursue you for repayment, which can have unfavorable transferable consequences, such as negative credit reporting, lawsuits, and long-term financial consequences. Therefore, it should go without saying that you want to be certain of the responsibility you are signing up for.

How Co-Signing a Loan Affects Your Credit

Co-signing a loan will impact your credit capacity in several ways, from payments showing on your credit report to debt ratios involved, and even payments that are close to or missed.

1. The Loan Shows Up on Your Credit Report

Once you co-sign, the loan will be shown as your debt on your credit report. The lender will see the stated loan balance, how the payments were made, and any missed payments, and this could reduce your credit score. However, the main co-signer makes the payments on time, but the loan may affect your credit history and your ability to borrow money. 

2. Increased Debt-to-Income Ratio

When you co-sign a loan, you are increasing your total debt, which would impact your debt-to-income ratio (DTI) because it is a combination of what you owe compared to what you earn. A higher DTI may limit your ability to obtain new credit or loans for personal needs, such as a mortgage, a car loan, or a credit card. This limitation could have long-term implications for your finances.

3. The Effect of Late Payments

If you have failed to pay or are late in paying, this will be reported to credit bureaus and will directly impact your credit score. Even if you demonstrate excellent payment behavior on an individual basis, having delinquencies on a co-signed loan can negatively impact your credit score when being evaluated for more favorable credit options.

The Risk of Defaulting on the Loan

When a co-signed loan defaults, it can lead to substantial financial and legal exposure, which may affect your credit and future finances. 

1. Full Responsibility for the Loan

Encourage the borrower to adopt sound money habits, such as budgeting, making timely payments, and reducing debt. Credit-builder loans or secured credit cards are alternatives that help build credit and limit reliance on a co-signer, so the borrower can be more self-sufficient and reduce their risk.

2. Debt Collection and Credit Damage

Defaulted loans may lead to aggressive debt recovery practices. Lenders can report such non-payments, outsource debt collection, or even file a lawsuit to recover the debt. These interventions will damage your credit, may result in wage garnishment, and could even lead to a lien on your property, causing long-term financial problems.

3. Negative Impact on Your Ability to Borrow

Defaulting on a co-signed loan will hurt your creditworthiness and limit your ability to secure new loans or credit cards. Even responsible borrowers may encounter difficulty obtaining a mortgage, auto loan, or personal loan, since lenders consider a default on a co-signed loan a significant liability.

The Psychological Toll of Co-Signing Loans

Co-signing a loan may lead to stress and tension that negatively impact relationship health and result in payment default or situations that may go out of control upon default. 

1. Relationships

Financing can become an overwhelming responsibility and bring tension between the borrower and the co-signer. It can cause stress over missed payments, leading to resentment, anger, or feelings of betrayal. This tension can be even more so for family or friends and can permanently damage personal relationships when co-signing a loan. 

2. Emotional Stress of Being Responsible

It can be difficult to your psyche to know that your credit is in an exposed state. Being stressed by the repayment capacity of the borrower may strain and suffer your mind psychologically, which can have a toll on your personal finances and well-being. Most of these pessimistic sentiments exist until the loan is repaid or refinanced.

Why Co-Signing Loans Is a Financial Risk

Co-signers face financial ambiguity because they have no say over the loan and are fully responsible for it.

1. Lack of Control Over the Loan

When you co-sign a loan, you are placing your faith in the borrower; however, you have no control over how they use the loan or their spending habits. Your credit is now linked to their creditworthiness, and you need to determine whether they are financially responsible before co-signing a loan.

2. Impact on Your Financial Flexibility

Co-signing a loan can limit your ability to borrow for personal needs, such as buying a house or a car. Your financial flexibility is limited, as lenders will apply a co-signed loan to other obligations, thereby impacting your plans.

3. Potential for Damaging Your Credit Long-Term

Negative activity associated with a co-signed loan–even late payments or defaults–can appear on your credit report for years. Regularly monitoring your credit allows you to identify and address issues early, helping protect your financial health in the long term.

Use Beem to get beneficial insights on where to cut costs, where to spend and how to save your money with your personalized Budget Planner.

Alternatives to Co-Signing Loans

You can help a borrower without risking your credit by taking other avenues to support them while keeping your finances safe.

1. Assist Borrowers Without Being a Co-Signer

You can provide financial planning advice, assist with smaller payments, or direct them to lenders that do not require a co-signer. This way, you can help but not jeopardize your own creditworthiness.

2. Support Smart Money Management for Autonomy

Encourage budgeting, on-time payments, and debt reduction. Recommend secured credit cards or credit-building loans to help them cultivate good financial habits and decrease their dependence on your assistance.

3. Research credit unions and other lending services

Consider things like credit unions, peer-to-peer lending, and other government-backed programs that will lend money on your behalf and do not require a co-signer, and frequently offer lower rates of interest and more flexible repayment options.

What to Do if You’ve Already Co-Signed a Loan

When you are already a co-signer, you should take measures to reduce the risk of credit damage and financial losses. 

1. Keep a Close Eye on Loan Activity

Be on the lookout for loan payments and watch your credit reports carefully. Set alerts to help ensure you catch missed payments as soon as possible and avoid long-term credit damage.

2. Create a Written Payment Plan

Be candid with the borrower and establish a written agreement to make the repayment process transparent and to alleviate confusion or disputes.

3. Make Payments to Preserve Credit 

If the borrower defaults on their payment obligation, make the necessary payments to protect your credit score and, at the same time, work with the borrower to establish a regular payment schedule.

Conclusion

By co-signing a loan, you are taking on financial and emotional risk that may have repercussions on your credit and your relationship with the borrower. There are many risks, including being legally obligated to pay if the borrower does not, missed payments, potential default, and strain on your relationship. To avoid these risks, consider offering partial financial help, financial counseling, or referring the borrower to a financial institution.

Protect your credit score while checking on the payments, and find if you have missed any payments. However, the most important thing is to protect your financial future, and that may require taking actions that the borrower may not understand, thereby risking your credit or finances. Download the Beem app here.

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