A co-signer is a person other than the individual borrowing money who agrees to be responsible for payments on the loan if the borrower stops paying. Since this is taking on a big risk, it's a good idea only to co-sign loans for relatives or close friends you trust very well. Co-signing a loan can also affect your credit rating, so make sure you understand the ramifications of signing a loan.
TL;DR (Too Long; Didn't Read)
A co-signer agrees to be responsible for a loan or other contract, such as a lease, if the main signer stops paying. It's a big risk, but it can also be a way to help a trusted loved one build credit.
Understanding How Co-Signing Loans Works
In many cases, a person taking out a loan from a bank or another institution can do so on their own. There's no need to involve anyone in the process other than the borrower and the lender. But if the borrower has a bad credit history or simply a limited one, or limited income, the lender may be skeptical about lending out the money or may require an exorbitant interest rate.
One way to avoid this problem is to have a co-signer on the loan. This is a second person who will formally pledge to pay back the loan if the main borrower fails to do so. In the ideal case, the main borrower will pay back the loan and the co-signer will not have to be further involved.
For example, you might add a co-signer to a car loan to enable someone who otherwise couldn't borrow the money to buy a car. You could also co-sign to help someone refinance a car loan.
Risks of Co-Signing a Loan
If the borrower fails to pay back the loan for any reason, the lender can come after the co-signer as if they were the primary borrower. That can include sending demand letters and calls from collection agents, and it can even include filing lawsuits to garnish wages, seize assets or otherwise collect money from the co-signer.
Co-signers can sometimes also be involved in other kinds of contracts, particularly leases. It's not uncommon for parents to co-sign leases when their children are renting their first apartments, particularly in expensive jurisdictions.
If you're asked to co-sign a loan, think carefully about your relationship with the borrower and whether it is worth it to you, and whether you trust that person to properly repay the loan. If you're deciding whether to ask someone to co-sign a loan, have the same thoughts about yourself, whether you're likely to repay and how it may impact your relationship with your co-signer if you don't do so.
Co-Signing Loans and Credit Ratings
If you co-sign a loan, it may appear on your credit report as if it were your debt and affect your credit score. It may raise your debt-to-income ratio, which may make it harder to borrow more money or open credit card accounts while the loan is outstanding.
If the borrower skips payments or makes them late, that may also count against you. In theory, you could communicate with the borrower and help with any payments to avoid this happening, but whether this is practical will depend on your relationship with the borrower and your financial resources.
Releasing a Co-Signer
Some loans provide arrangements where a co-signer can be removed, or released, from the contract when certain conditions are met, such as after a certain number of payments are made without issue. Look or negotiate for such an agreement when you're setting up a loan with a co-signer.
Another way to remove a co-signer from a loan is by refinancing it, effectively borrowing money from the same or another source without a co-signer to pay off the initial loan. For instance, you could refinance an auto loan with a co-signer to remove the co-signer, as well as to potentially get a lower interest rate.
This may be possible if the borrower's credit improves. It's often harder to refinance a car with bad credit or to refinance any other loan. Also keep in mind that some loans have prepayment penalties that make refinancing costly.
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.