Building credit is tough. Each of us starts the journey from having no credit score, so getting our foot in the door can be tricky.
That's why young adults or people with poor credit scores often turn to older friends and family members with solid credit scores for assistance when trying to buy a house or car.
So should you help out a friend or family member by co-signing on a loan? The answer is almost always "no."
It sounds harsh, but our Dear Penny inbox is constantly flooded with questions and regrets related to co-signing, like this woman who destroyed her credit after co-signing for a friend and this parent who put her retirement at risk when she co-signed for her daughter's car.
"With co-signing, the thing you have to remember is that lenders want to lend money and charge you interest," says Robin Hartill, senior editor of The Penny Hoarder and certified financial planner. "When they refuse to lend to someone, they're passing on the chance to make money because they think it's too big a risk."
So if lenders say no, chances are good you should say no too.
Risks of Co-Signing a Loan
The risks of saying yes to co-signing are many -- and they can have a real, long-term impact on your financial well-being. Here are some things to consider before co-signing a loan.
Your Credit Is at Risk
As the co-signer of a loan, you're putting the debt in your name. That means the loan will appear on your credit report, and any late payments by the borrower will reflect as a late payment by you. Any delinquent payments will adversely affect your credit score, and if the borrower makes this a regular habit, you may have to step in and spend your own money to protect your credit score.
Your Hard-Earned Cash Is at Risk, Too
When you co-sign for a loan, your signature is not meant to be a vote of confidence to assuage a lender. You are agreeing to pay the entirety of the loan if the borrower stops making payments.
Before co-signing, consider this: Could you afford to make those payments each month until the car, house or other financed item is paid off?
Remember that you'll have nothing to show for those payments, because the borrower is the one who keeps the car, lives in the house, gets the college education, etc. That is, of course, unless the car is repossessed or the house is foreclosed on.
If you, as the co-signer, do not make the payments when the borrower stops, the bank will step in -- and this will affect your credit. The lender can also sue you, which could ultimately result in a lien on your home or garnishing of your wages.
Your Relationship Is Not Immune, Either
Financial consequences aside, co-signing for a loved one could also lead to a strained relationship -- or even estrangement.
Before co-signing, ask yourself this: If the borrower ultimately decides not to hold up their end of the bargain, how will that affect your relationship? Will you be a "helicopter co-signer" who regularly checks in on their finances, risking resentment on their end? Will you know how to talk to the co-signer about missed payments? What happens if your borrower refuses to pay; will you lose that relationship?
"I'd caution people to think very carefully about the harm co-signing can do to a relationship," Hartill said. "Co-signing is something you do to help someone you care about. But if they fail to do what they agree to and your finances suffer as a result, it's going to be tough to mend that relationship."
What You Should Do If You Co-Sign a Loan
Sometimes, saying no is impossible. Private student loans, for example, typically require a co-signer, forcing parents to sign their life away in the interest of their child's education. As the co-signer for any type of loan, you can protect your investment and credit by:
Request Monthly Statements
As the co-signer, you can ask the lender to send a copy of monthly statements to you as well as the primary borrower. You can also request alerts for missed payments and access to the online payment portal. This allows you to stay on top of payments and make them if it is clear the borrow cannot or will not.
Pro Tip - If you make a payment on behalf of the borrower to protect your credit score, you are setting a precedent. In the borrower's eyes, you are now available to make payments any time they don't want to.
Plan for a Refinance
The whole point of co-signing for a friend or family member is to help them get on their feet while they build up their own credit. That means, after a few years of responsible payments, they could have the credit score to handle a loan on their own. In that case, you and the borrower could attempt to refinance the loan without your signature.
Pro Tip - Set a goal of refinancing from the start of the co-signing process, and actively work to motivate the borrower to improve their credit so they can be in good standing to refinance when the time comes.
Petition for a Co-Signer Release
If you desperately want to be removed from a loan as a co-signer, you can request a release form. However, the primary borrower must sign off on the release form, and the lender must approve it. Those are two tough hurdles to jump through.
If the borrower is enjoying a house or a car that you've been making payments on for them, they may not be likely to sign the release form. And if their credit score is still low and the lender deems them to be too risky, the lender will not sign off on the form, even if the borrower has.
Alternatives to Co-Signing
Saying no to a friend or family member in need can be tough, but there are other ways you can help if you are not comfortable being a co-signer on a loan.
Gift a Down Payment
Often, a borrower has a better chance of getting approved for a loan if they make a large down payment. To avoid the need to co-sign, offer to pay the down payment as a one-time gift, if you can afford it. Alternatively, you can offer to loan them the money for their down payment with a solid repayment plan. Understand, though, that they will be under no legal obligation to pay such an informal loan back, so don't give away money that you absolutely must get back.
Help Build Their Credit
If the borrower can wait another year or two to make their purchase, offer to help them build their credit score to a place where they could get the loan themselves. For example, you can make them an authorized user on your credit card, which can influence their credit score.
Pro Tip - Don't trust them with your credit card? Make them an authorized user but hold on to the card and don't give out the card number. Their credit will still benefit if you're responsible with the card.
You can also help them build their credit score by making sure they make all payments (rent, utilities, credit card payments) on time and in full each month over a long period of time. If they're having a tough month, offer to step in and help pay for rent.
Suggest a Bad Credit Loan
Some lenders will offer loans to borrowers with poor credit. These loans typically carry unfavorable terms, like high interest rates. Instead of co-signing for a loan, offer your friend or family member to pay a portion of their interest each month on a "bad credit loan" until the borrower's credit score is strong enough for the borrower to refinance at a better rate with a different lender -- and without your help.
This story was originally published by The Penny Hoarder.
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