101: Co-Signing a Loan/ February 3rd, 2018
Co-signing a loan means you are legally responsible for repayment of someone else's debt. That's why it's a pretty big ask.
You’re lending your good name and your solid credit history to help someone else get approved for a loan or a credit card. And you’re making a promise to repay in full if the original borrower can’t, doesn’t, or just plain won’t.
The impact of co-signing can go even further:
- Your credit score could change. The amount of the debt and any missed payments become part of your own credit history. A lower score might hurt you in applying for a future loan, resulting in a higher rate or even a rejection.
- If the borrower defaults, collectors might come to you for payment. Take, for example, a car loan where the borrower defaults. Even if the car is repossessed, you may have to pay if its value is not enough to cover the outstanding balance.
Those two considerations could scare off just about anyone from co-signing on a loan or credit card. Co-signing is serious business, not just a good turn for someone in need.
That said, there are good reasons to co-sign a loan in certain situations.
Co-signers can help young family members
If you have a solid credit history and a strong credit score, your additional signature on a loan could lower the rate. Young adults often have little or no credit history. Applying on their own, they could face higher rates (to cover risk to the lender) or be turned down entirely.
Say your 22-year-old daughter Megan is ready to buy a car. She has a steady job and can handle the payments, insurance, and upkeep—but she has no credit history. You think she’s responsible enough to handle this obligation, but to a lender she’s an unknown risk; a lender might offer a higher rate to compensate for the risk.
By co-signing, your strong credit score could reduce that rate.
Your signature also may be the only way for someone younger than 21 to get a credit card. Federal rules that took effect in 2010 require anyone younger than 21 who wants to open a credit card account to show ability to make payments.
Let’s imagine your son Max is headed to college. Even with $4,500 on deposit in his savings account, a lender likely will ask for a co-signer on a credit card application. When you co-sign his application, you help Max establish a credit history—and you have another opportunity to coach him toward responsible money management.
How to make it work
Follow these three guidelines to make co-signing successful:
As a co-signer on a loan or credit card application, you are lending your good name and your solid credit history.
Set up automated payments. The best way to build a strong credit history is to make every payment on time. Before you co-sign for a loan, insist on establishing automated monthly payments from a credit union account.
This action protects your credit history and helps the borrower build one. The No. 1 factor in calculating a credit score is payment history, according to the Fair Isaac Corporation, creator of the widely used FICO score.
If you’re co-signing for a credit card, consider automated payments to cover 5% or more of the card limit ($25 on a $500 limit). This protects you both against a missed payment, which could increase the rate. The borrower can make additional payments every month to pay off the statement balance.
Agree to limits. Know when you’re getting out before you get in. For a loan, aim for three years or less. If that’s not practical, make it clear you’ll act as a co-signer for just three years; then revisit the credit union to renegotiate the loan without your signature.
For a credit card, start with a low limit. Since debit cards are widely accepted, there’s little need for a $5,000 credit limit. A thousand dollars, even $500, might be a good place to start. As a co-signing parent, you’ll be notified of any request to raise the credit limit. And once your son or daughter reaches age 21, visit the credit union to remove your name from the account.
Share payment notifications. As a co-signer, you have the right to see statements and payment notifications. The easiest way may be through shared online access. This gives you the opportunity to step in before an accidentally missed payment turns into a past-due problem.
Be a credit coach but avoid the temptation to criticize credit card purchases. Yes, $165 for a new black North Face jacket is not practical when there’s a perfectly good brown one in the closet, but making mistakes is part of the process of learning to manage money. The borrower soon will learn that paying off that new jacket means taking on a couple of extra shifts or staying in when friends go out for the next couple of weeks.
By following these suggestions, you lay out your expectations before co-signing. Being frank will help protect your financial standing and also can maintain your positive relationship with your borrower.
Be sure to talk with someone at the credit union if you have any questions or concerns.