If your significant other has poor credit or if you want to start a business venture and need to secure financing, you may find yourself being propelled into the role of a loan guarantor. As a loan guarantor, you basically act as the back up if a consumer or business borrower proves unwilling or unable to pay off a debt. Guaranteeing a loan does have an impact on your credit score and in some cases can be very damaging.
TL;DR (Too Long; Didn't Read)
When you guarantee a loan, your credit score drops some due to the new credit application and reduced account history length. If the primary borrower defaults, your credit score can suffer more if you can't pay back the loan.
New Credit Application
About 10 percent of your overall credit score depends on the number of recent credit applications that you have submitted. Your credit score drops a few points whenever you apply for credit because credit bureaus see applications as a warning sign that you may have run into financial problems.
When you agree to act as a loan guarantor, the lender has to check your credit report because you are responsible for paying the loan if the primary borrower reneges on the debt. Needless to say, lenders like guarantors with good credit rather than people who cannot pay their own debts. The credit check hurts your score, but it should recover within a few months as long as you stay on top of your own debt obligations.
Account History Length
Your average length of account history also appears on your credit report, and this accounts for 15 percent of your total score. As a guarantor, you are not responsible for paying on the loan unless the borrower defaults. Nevertheless, lenders still report the debt to the bureau because the borrower could default at any time, meaning the loan becomes your problem.
The presence of a new loan on your credit profile reduces your average length of credit history, and this also hurts your score. The more well-established accounts you have, the less damage the new account can do.
Effects of Default
Although the loan appears on your credit report, the loan balance and late payments have no impact on your credit score because you are not responsible for paying the debt unless it actually goes into default. Even then, laws in most states require lenders to exhaust all avenues to collect the debt from the primary borrower before even contacting the guarantor.
Obviously, if you guarantee a loan for your significant other, the lender's attempts to collect on the debt will directly impact you. You may not hear anything about debt collection if you co-sign on a loan for a sibling or friend.
Repayment as a Last Resort
If all else fails, the lender can invoke the clause requiring you to pay off the debt. If you settle the matter without delay, then it has no impact on your credit score. However, if you cannot afford to do so, the lender can take you to court an obtain a judgment against you.
Judgments are recorded on your credit report and can cause your score to drop dramatically. Worse still, a judgment remains on your credit report for up to seven years. Therefore, your role as a guarantor could limit your access to credit for many years to come.