It’s tempting to co-sign a loan for a friend or loved one who can't get a loan on his own, or needs help establishing and building good credit. But co-signing comes with a lot of pitfalls, not the least of which is the impact it has on your debt-to-income ratio.
Cosigning a loan raises your debt-to-income ratio since you're basically promising to pay the loan if the borrower doesn't. It also puts you at risk for damaging your credit score and having your wages garnished for non-payment.
Understanding Your Debt-to-Income Ratio
Your debt-to-income ratio, or DTI, measures the amount of debt you owe each month versus the grossly monthly income you earn. For example, if your recurring monthly debt is $1,000 and your gross monthly income is $5,000, your DTI is 20, which means 20 percent of your income goes to recurring debt. This number is arguably as important as your credit score in determining whether you qualify for a loan, and the lower the number, the better. As a general rule, any number over 36 will cause lenders to question whether you can afford additional loan or credit payments.
Promising to Pay
When you co-sign on a loan, you might think that you’re simply vouching for the other party to be responsible and pay back the debt. In reality, by co-signing you’re effectively promising to take over payments on the loan if the borrower stops making payments for any reason. By adding your name to the loan agreement, it’s essentially the same as taking out the loan yourself, regardless of any agreement between you and the other borrower.
Exploring the Impact on DTI
Because you’re ultimately responsible for any loans on which you’re a co-signer, lenders treat those loans just like any other loan or line of credit in your name. Co-signed loans are included in determining your DTI. Because of this, co-signing can potentially inflate your DTI number and prevent you from being able to obtain a loan or line of credit for yourself.
Knowing the Risks of Cosigning
Besides the effect it can have on your DTI, co-signing a loan carries other risks. According to Bankrate.com, once a payment is missed, the lender can choose to pursue payment from whomever he thinks is best able to pay the loan in the quickest manner. If that’s you, then he can come after you for payment without bothering to exhaust all avenues with the original borrower.
Late or missed payments on the loan, or repossession of the item that the loan covered, will also show up on your credit report and negatively impact your credit score. Also, if the lender decides to sue for back payments, you could end up having your wages garnished and having to pay attorney’s fees.