Risk and Responsibility: Should You Cosign on a Loan?

Source: Thinkstock

Source: Thinkstock

Cosigning on a loan is a big decision, because you will potentially be responsible for someone else’s debt. This decision can affect your credit, because if the other person doesn’t pay their loan, you will be responsible for it, and because of the fact that isn’t being paid it may show up on your report. Cosigning a loan can also affect you when you try to open other credit. However, cosigning a loan can be a great way to help someone else out, especially someone who has never had a loan or has a very limited credit history; this is often the case for children who are first entering the world of borrowing. Helping out a family member in need can be a great way to show support, but before you offer your help, make sure you consider whether or not you are taking a safe financial risk.

Before you cosign on a loan, be sure to consider all the different aspects of cosigning. The first question you should answer is whether or not you are comfortable if you never get paid back for the loan if the other person defaults. Despite the best intentions, the person you are cosigning with may never be able to pay you back. This also means that you need to be comfortable making the loan payments yourself if the other person fails to pay. If you are cosigning for a family member (like your son or daughter) you may be okay with this, but think carefully about whether or not you are truly comfortable if you have to make the payments.

Your answer to this question might change if you are considering cosigning for a friend; if your friend doesn’t pay the loan, will you be comfortable paying it for as long as necessary (and potentially never getting paid back?) If you decide not to pay the loan, your credit score will suffer.

You also need to determine if you can afford to pay the loan. No matter how reliable the other person seems, if they stop paying, you will have to pay. If you can’t afford to pay, you may not want to cosign at all because you could get sued later. If the lender allows you, specify what your own financial obligations will be if the other person defaults, and make sure you include it in the contract. Make sure you have copies of all important paperwork.

If possible, determine if the person you are offering to share a loan with is reliable. If they have never had loans before, this might be difficult. You can’t guarantee that they will pay the loans, but if you know that they often display irresponsible behavior (returning movies late, borrowing cash and never paying it back, etc.) then you might be making a risky venture. If the person needs a cosigner because their credit has gotten so poor that they can’t get a loan (despite previous loans) that is another red flag. If the other person refuses or is unable to pay the loan payments, not only will you be stuck making the payments, but if you need to open other credit, lenders will consider the loan when determining whether or not to give you a different loan. The loan will also affect your ratio of credit available to credit used.

Another issue to consider is the importance of the friendship or family relationship. If you are considering cosigning a loan, then you are probably close to the person that you are willing to sign for. Although saying no might temporarily hurt the relationship, if you say yes and then problems arise during repayment, it could cause a lasting rift between you. Although the loan does not belong to you (because you are not a co-borrower), if the other person defaults, it will become your responsibility, and that can foster resentment and negatively alter a relationship.

You will also be tied to the other person for the entirety of the loan period, which means that if a relationship suffers, you will still need to deal with that person (unless you just pay the loan.) It’s also possible that your friend or family member will run into unexpected circumstances (rather than just refusing to pay or being irresponsible), but either way this can affect you.

There are of course some positives to cosigning a loan. The most obvious is that you will show support to your friend or family member, and if they are young, you may be able to help teach them some financial responsibility. You also may find that cosigning a loan actually improves your relationship and brings you closer, because you may foster a relationship that includes trust.

More From Wall St. Cheat Sheet: