What You Need to Know Before Co-signing a Loan
When you co-sign a loan, you agree to take on certain financial responsibilities — generally, you agree to step in if the borrower misses a payment. Co-signing a loan can help a borrower secure more favorable loan terms, such as a lower interest rate. According to Credible, adding a co-signer to a student loan reduces the interest rate by an average of 2.36 percent. If a friend or family member approaches you with a request to co-sign, don't hesitate to ask questions. Co-signing a loan shouldn't be taken lightly; your name will be on the legal documents and you'll be financially obligated to pay back the loan if the borrower isn't able to.
Types of Loans You Can Co-Sign
Co-signing a loan is more common in certain situations. According to the Consumer Financial Protection Bureau (CFPB), 90 percent of private student loans are co-signed. This is likely due to the fact that most student loan borrowers have little, if any, established credit history. Mortgage loans may also be co-signed, as long as co-signers meet eligibility requirements set by the Federal Housing Administration (FHA) or the individual lender. You can also co-sign auto loans or personal loans.
How Co-Signing a Loan Affects Your Finances
Before adding your name to a loan, understand how your personal finances will be affected. Though you might not expect to make any payments, the loan will still appear on your credit report, says Experian. The unpaid loan amount will also be factored into your debt-to-income (DTI) ratio, which is used by lenders when approving new loans. If the borrower makes a late payment or doesn't pay at all, it could affect your ability to secure a loan when you're ready to buy a new car or a house.
Before co-signing, ask yourself how well you know the person you're helping. Are they willing to discuss their financial situation and their ability to pay off the loan? What are the chances that you'll need to step in and pay the balance?
What Co-Signers Need to Know
Before agreeing to co-sign, make sure you understand your obligation to pay as well as why the borrower needs a co-signer. Are they a recent graduate looking for a higher paying job? Do they expect an increase in their income, or are they consolidating and paying down debt to improve their credit? Request information, such as the total loan obligation (including interest), the monthly payment amount, and what your legal responsibilities are. You may be able to request your removal from some co-signed loans after a set period of time. Mortgage co-signers can also be removed from a loan if the borrower refinances due to an improved credit score and a higher income.
Exploring Other Options
In addition to considering the financial impact of co-signing, you should also carefully weigh the interpersonal factor. Your relationship with the borrower may be affected whether you agree or decline to co-sign. If you don't feel comfortable co-signing but would still like to help, there are other options.
If you provide financial assistance on a more informal basis — by loaning money to the person directly, for instance — it may be easier to cut financial ties and could help the borrower in the short term. If you're their parent or grandparent, you may also choose to gift them funds. According to the 2019 IRS rules, you can gift up to $15,000 tax-free to a child or grandchild.
Before co-signing a loan, make sure you understand the long-term effects it could have on your finances. If you have any questions about co-signing or about alternate options, don't hesitate to speak to a financial advisor or lender.