Co-signing is a dangerous proposition. As much as you believe in your friends and family members and their ability to repay loans, being a co-signer can not only put you on the hook for paying when financial emergencies strike, but it can also prevent you from getting a loan yourself.
Effects of Co-signing
When you co-sign for a loan, you’re treated as if you took out the loan yourself when it comes to responsibility for the debt and to its effects on your credit score. Obviously, if the borrower defaults on the loan, you’ve got to pay off the balance. Not as obvious is the fact that the loan shows up on your credit report, just like any other loan in your name. Since your credit report affects your credit score, and lenders look at both your credit report and your credit score when deciding whether to approve you for your own loan, your generosity in co-signing could come back to bite you.
Banks Fear Large Debts
You might be credited with owing a large chunk of change, depending on what you co-signed for on the loan. According to the Fair Isaac Corporation, which developed the most widely used credit scoring formula, your amounts owed account for 30 percent of your credit score. For example, if you co-signed a small personal loan for a friend, the amount of the loan won’t add too much to your outstanding debt, so it will have a smaller impact on your ability to get a loan. However, if you co-signed for a larger loan, like a student loan or a mortgage, you’re going to have a much harder time getting a loan for yourself.
Late Payments Hurt You
Since the loan you co-sign for also appears on your credit score as if it were your own, any late payments made by the primary borrower are going to knock your score. For example, if the primary borrower forgets to make the payment one month, even if you don’t find out about it until a month later, you’re credit score will still show a late payment, and lenders are more hesitant to make loans to people with poor payment histories. The converse is also true, however, so if the person you cosign for makes all the payments on time, your credit score benefits. Your payment history accounts for 35 percent of your credit score, so while one late payment won't ruin your score, a string of late payments can cause trouble when you apply for credit in the future.
Minimizing Your Exposure
To minimize the effects of co-signing a loan on your own credit score, make sure you read and understand the terms of the loan. For example, check to see what, if any, collateral you are using to support the loan. If you're pledging your house or car, other lenders will be less likely to let you use the same property as collateral. In addition, you may be able to negotiate to have your co-signing liability limited to just the principal so you won't be stuck owing interest, penalties or other fees.
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