Pros and Cons of Cosigning a Loan: Things to Consider

Cosigning a loan is a significant financial decision that you shouldn’t take lightly. On one hand, they’re an excellent way to help a loved one rebuild bad credit, make a big purchase, or apply for student loans. On the other hand, attaching your name to someone else’s debt that they don’t repay can have severe consequences for your own finances. You should understand the pros and cons of cosigning a loan before making a decision so you can properly weigh your options.

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What does cosigning a loan mean?

Cosigning a loan means agreeing to repay its amount in full if the primary borrower can’t do so. Even if you never have to make payments yourself, the loan still appears in your credit report.  It’ll come up each and every time any person or institution conducts a credit check on you, and it could impact your credit score.

Potential benefits of cosigning a loan

Cosigning a loan might seem too risky, but doing so can make a huge difference for a loved one. The below benefits of cosigning a loan can be meaningful for either you or someone in your life – or both.

  • Great way to help

Most lenders don’t want to hand out money to potential borrowers who present too much financial risk. Generally, they’ll reject anyone who doesn't seem like they could pay back the amount in a reasonable time frame. The lender looks at many factors to determine eligibility, and often, the most impactful is a borrower’s credit score. More likely than not, if a borrower has a bad credit score, they won’t qualify for most high-quality loans.

That can change if you cosign the borrower’s application and loan. If you do so and you have good credit, you can make the borrower much more attractive to lenders. With your help, many more loan options become within reach.

  • Could improve credit

Building credit is a matter of regularly making monthly payments on debts for an extended period. That typically makes it tough for younger borrowers to have much of a credit history at all. Many younger borrowers haven’t yet borrowed often, so they don’t have the credentials to qualify for the very loans that could build their history.

However, if you cosign a loan and you have strong credit, you can improve their eligibility for credit cards and loans. If the borrowers continually repay their credit cards and loans back on time, their credit history will improve. That’s why cosigning can be a great way to help a loved one build credit with a limited history. In fact, with regular bill and loan payments, a cosigner might not be necessary in the future.

  • Might mean lower interest rates

When you cosign a loan, you enable the borrower to seek better loan offers than what they originally had available. Your cosigning gives lenders easy recourse if the borrower fails to repay, reducing the lender’s risk and allowing them to offer more generous loan terms. As a result, the borrower may see lower interest rates, longer repayment periods, and smaller monthly loan installments.

Potential disadvantages of cosigning a loan

Many of the disadvantages of cosigning a loan fall directly on your shoulders. While you’re potentially helping a loved one, doing so can put your personal finances at risk. These drawbacks are something to discuss with the primary borrower before making a final decision.

  • It’s harder to borrow

Many lenders decide whether to approve a potential borrower's application based on their debt-to-income ratio. Even if you never help pay for the borrower’s loan, it’s still added to your credit history too – and often without context. The primary borrower's loan could distort your own ratio of how much you owe versus how much you earn. That could make certain lenders more likely to reject your application.

  • Your credit score could drop

The loan’s repayment status also becomes part of your credit history. If the primary borrower is late on a payment or misses it completely, your credit score will drop too. Likewise, if the loan goes to collections for nonpayment, you could face debt collectors, garnished wages, and property or UCC liens.

  • You could ruin your relationship with the borrower

Any financial hardship the borrower experiences could become yours too. You could be stuck repaying their loan or fending off debt collectors. It can be tough to interact with the borrower if they’ve saddled you with these financial difficulties.

The best way to avoid hard feelings is to view your cosigning as a gift to the borrower. That can entail overlooking any problems the borrower could have with paying the loan. If that’s not possible for you, it’s probably best not to sign at all.

What are the financial consequences of co-signing a loan?

It’s essential to fully understand the potential monetary consequences of cosigning a loan so you can make a more educated decision. Here’s a primer on the biggest potential effects on your finances.

The loan could become your responsibility.

If the original borrower can’t pay their monthly bill, you’ll be required to pay instead. That could eat away at funds you’d saved for an emergency. In turn, if you face an unexpected expense as you’re unexpectedly saddled with monthly loan payments, you’ll be less prepared to handle it.

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It appears on your credit report

After co-signing the loan, it appears on your credit report, as do any negative aspects of the loan. For example, if the primary borrower misses payments or their loan gets sent to collections, your credit report will suffer too. When there are problems with a loan you’ve co-signed, you can face challenges getting other loans in the future.

You’re legally on the line

Because cosigning means accepting equal responsibility for the loan, lenders are within their right to sue you if the amount isn’t repaid. A court could order your wages garnished to pay for the loan and any legal fees. The good news is that there are other ways to help your loved ones find funding opportunities that work for them.

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Like most financial decisions, cosigning a loan isn’t something you should jump into without prior consideration. Before putting your name on a loved one's contract, you should consider the worst-case scenario and decide whether you’d be okay with facing it.

That said, there’s no denying that your assistance can help a friend or family member find opportunities that weren’t possible before. You can help your loved ones in this way without cosigning their loans. If you’d like to help someone in your life find the best feasible loans without signing your name, you can refer them to SmartBiz. Your loved one can check whether they pre-qualify* for SBA 7(a) loans, bank term loans, or custom financing for whatever they need.

*We conduct a soft credit pull that will not affect your credit score. However, in processing your loan application, the lenders with whom we work will request your full credit report from one or more consumer reporting agencies, which is considered a hard credit pull and happens after your application is in the funding process and matched with a lender who is likely to fund your loan.

WHAT YOU NEED TO KNOW: The SmartBiz® Small Business Blog and other related communications from SmartBiz Loans® are intended to provide general information on relevant topics for managing small businesses. Be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed. Please consult legal and financial processionals for further information.

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