In the world that we live in today, most people will carry debt at some point. Being approved for and paying for debt becomes a lot easier and more affordable with a high credit score (read about why your credit score matters). However, when someone doesn’t have a good credit score, being approved for a loan can become difficult.
A common way for people seeking a loan to increase their odds of approval is to have someone cosign the loan. From the perspective of the primary borrower, having a cosigner is a good deal. From the perspective of the cosigner, this may bring far more risk than you expect or are willing to shoulder.
Although there are some benefits to cosigning a loan (increasing credit score and supporting loved ones), the negative consequences far outweigh the benefits. Here is a summary of the pros and cons of cosigning a loan.
Pros of Cosigning
1) Increasing the cosigners credit score
When you cosign a loan it shows up on your credit report. As long as the payments are made on time and the balance stays in good standing, cosigning can help increase your credit score.
2) Helping loved ones
Cosigning a loan can help the primary borrower obtain better financing options. It can help in the process of attaining the loan, help qualify for a more competitive interest rate, and help to avoid predatory lenders.
Cons of Cosigning
1) High Risk, low reward
With cosigning a loan there is a lot of risk involved. Your credit score only benefits slightly from the monthly payments when cosigning a loan. However, that is a small reward for taking on the risk involved. If the primary borrower can’t make monthly payments or they fall behind with late payments, it is likely to affect the cosigners credit score negatively.
2) The lender will come after the cosigner first
If the primary borrower defaults on the loan, the lender will come after the cosigner first. The cosigner has just as much responsibility to make sure that the payments are made as the primary borrower. That is why it is crucial to make sure that you can afford the payments if the primary borrower were suddenly unable to make the payments.
3) Decreases the cosigner’s chance of loan approval
Since the cosigner has an obligation to make payments on the cosigned loan, it can decrease their chance of being approved for a loan in the future. Being a cosigner increases your debt-to-income ratio. Even though the primary borrower of the loan may be able to make payments, lenders still take the cosigning of a loan into consideration because there is a large amount of risk associated with the obligation.
4) Potential tax consequences
In the scenario that the loan does go into default, the lender may decide to settle a loan for a lesser value, if they believe that they will never get the full value. If a loan settles there are tax ramifications.
For example, if you have a $10,000 loan and the lender decides to settle it for $4,000, you will have to claim the $6,000 as debt forgiveness income.
5) The cosigner has 100% liability
As mentioned earlier, the co-signer is 100% liable for the loan. If the primary borrower cannot make the payments the lender will come after the cosigner. Additionally, if the lender calls the loan or chooses to foreclose, the cosigner will have to come up with the difference through the settlement process.
In summary, don’t rule out cosigning for your loved ones if you know they can manage their finances and make their payments on time. However, be aware of the potential negative financial consequences and likely emotional turmoil it would bring if they were unable to follow through on their obligations. Also, take into consideration the possibility of future financing. If you are going to need a loan in the future make sure the cosigning of a loan doesn’t decrease your chances of approval.
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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy.