Most of us have been there: a friend or relative wants to make a purchase, but their credit isn't good enough to qualify on their own. So they ask financially-responsible you to co-sign for their personal loan, their car, even their house. I don't care how much you love this person, or how hard it is for you to say "no," this is never, ever, ever a good idea.
In case you get tempted to break this rule, remember these five reasons why you don't want to:
You'll Be Limiting Your Own OptionsEven if your friend turns out to be a perfect borrower, and makes all his payments on time, a co-signed loan will still limit your own ability to borrow. Most loan underwriters assess your debt-to-income ratio as part of their decision whether to lend money. Your co-signed loan will show up as part of your debt, skewing your debt-to-income ratio. Even if you literally have no other debt, a co-signed loan could prevent you from making your own purchase.
This segues perfectly into the second reason that you don't want to co-sign a loan:
Your Credit Score Will SufferOne important part of your credit score is your debt utilization ratio. This ratio takes the total amount of credit you are using and compares it to the total amount of credit you have available to you. For example, if you have one credit card with a $1000 limit, and it has a balance of $300 on it, your debt utilization ratio would be 30%. Add a friend's $30,000 car loan, and suddenly your credit utilization ratio is almost 100% - not good. And this is the best case scenario, where your friend makes the payments.
If your friend does not make payments on time, expect to see your credit score plummet. And if it goes to collections, repossession or foreclosure, you are pretty much stuffed. There is no distinction between your debt and the co-signed debt, because co-signing makes it your debt.
The Payments Are Your Responsibility, But You Might Not Even Know If Your Friend Isn't PayingCo-signing a loan is exactly like taking out your own loan, except that you are hoping that your friend will pay. If they don't, you'll need to keep up the payments or risk all the bad things happening to your credit score. Worse, you might not even be notified if your friend isn't paying on time. Most loans only list contact information for one borrower. If your friend doesn't pay, the notices and phone calls will probably go to your friend until the situation has gone beyond serious.
Your Relationship Is More Important Than MoneyLife isn't perfect, and sometimes there are semi-legitimate reasons why a person might not pay their bills. If your best friend loses their job, you'd be able to provide moral support and maybe pick up a few bags of groceries once in a while. If you've co-signed on their car loan, you won't be able to do either of those things. Your friend's financial crisis will be your financial crisis as you struggle to keep up on the payments. And even the best person will find a friendship strained. No one wants that.
Banks Are Experienced Money Lenders, And There Is A Reason They Want A Co-SignerIf the lender is requiring a co-signer, it is because they feel that the person asking for the loan is not a good credit risk. The bank usually has a pretty good reason for this. Regardless of how you feel about your friend, please understand that banks are in the business of lending money. They do this every day. Through trial and error, they've developed profiles that identify people who are less likely to pay back their loan. Sure, the bank could be wrong. You could be wrong, too. Only one of these two possibilities has the potential to hurt you financially. Trust the lender's judgement. Save yourself the headache, the heartache, and the wallet-ache.
There are many happy endings in co-signing stories. The bad things that can happen are too large, however, for you to take the chance. Save yourself and your friend the hassle by declining any offers to co-sign a loan. You'll be protecting your own interests and maintaining your relationship at the same time.