Co-Signing a Loan: Risks, Benefits, & How It Works

Written by Kim PinnelliReviewed by Anders Skagerberg, CFP®Updated: 15th Apr 2022
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If a close friend or family member can’t get approved for financing they need, you might consider cosigning for them. While it sounds like an amazing thing to do for someone, it can be risky if you don’t know the consequences.

Here’s everything you must know before you choose to cosign a loan for someone.

What Is a Co-Signer?

A co-signer is someone with qualifying factors better than a borrower to help them get approved for a loan. A co-signer essentially guarantees the loan. You tell the lender that if the borrower can’t make their payments, you will be responsible for it. A co-signer has no interest in the funds or the asset the borrower uses the funds to buy.

The point of the co-signer is to improve your chances of loan approval. The borrower essentially uses your good qualifying factors to help them get the loan. Borrowers should only take on loans they can afford, though.

How Does Co-Signing a Loan Work?

When a borrower applies for a loan with a co-signer, you both provide your personal identifying information as well as financial information to qualify for the loan. The lender considers the information from all applicants to determine if the borrower is eligible for the loan.

Keep in mind, not all lenders or loan types allow co-signers. Always ask the lender first to make sure they allow it.

What Does a Co-Signer Do for a Loan?

A co-signer can make up for negative qualifying factors a borrower may have, such as a low credit score or high debt-to-income ratio. The right co-signer will have better qualifying factors than the borrower to help them get approved.

The right co-signer might help a borrower get a lower interest rate, better term, or even a higher loan amount. Again, borrowers should only take on a loan they know they can afford, no matter what the addition of a co-signer does for their loan.

How Is a Co-Signer’s Credit Affected?

As a co-signer, your credit is affected just like the borrower’s credit. The lender will do a hard credit inquiry when the borrower applies for the loan to determine if both applicants’ credit qualifies them for the loan. A credit inquiry usually hits a credit score for 5 points or so.

If the borrower is approved, the loan becomes a tradeline on both the borrower’s and co-signer’s credit report. All payment history and activity gets reported on both credit reports.

If the borrower makes the payments on time, both credit reports will show a great payment history and it will reflect positively in both credit scores. But, if the borrower doesn’t make their payments on time, it hurts not only their credit score but your credit too. Payment history is the largest part of a credit score.

Also, not making payments, or worse yet defaulting on the loan can damage everyone’s credit the most. As the co-signer, you are legally liable for the payments if the borrower doesn’t make them. But if you don’t make the payments either, both credit reports will show a defaulted credit line which damages a credit score considerably.

Is a Co-Signer Legally Obligated to Pay for the Loan?

This is the largest downside of co-signing on a loan. You are 100% legally responsible for the loan if the borrower doesn’t pay it. As the co-signer, you promise to pay the loan if the borrower doesn’t. Since the loan isn’t for an asset, you’ll benefit from, make sure the borrower can 100% pay the loan and isn’t just using someone else’s credentials so they can borrow more money than they can afford.

>> More: What Happens If I Default on a Personal Loan?

Risks of Co-Signing a Loan

Taking out a loan for yourself is risky but co-signing for someone else has even more risks. Here’s what you should know.

#1. You Are Responsible

We can’t stress it enough. Co-signers are responsible for the loan if the borrower doesn’t pay it. This is a risk even if the borrower makes a payment late because it can damage the co-signer’s credit. Knowing 100% that a borrower is capable of paying back the loan and just needs a little boost to qualify because of a previous hiccup in his/her credit can reduce this risk, but it’s always something to consider.

#2. Relationship Can Potentially Be Damaged

There’s a lot of trust on the line when you co-sign a loan. Even if the borrower has the best intentions of affording the loan and making the payments on time, but then can’t, it can ruin your relationship.

If the loan damages your good credit and/or makes you ineligible for future financing or at least good terms, it can cause trust issues in the relationship.

#3. You Can Be Sued

It sounds unreal, but in some states, the lender can sue the co-signer before suing the borrower for non-payment. If the borrower doesn’t make the payments, the lender knows he/she likely can’t afford it. But if there’s a co-signer, the lender can often sue the co-signer for the funds.

This is why it’s important to understand the risks involved in becoming a co-signer, including the financial risks.

#4. Your Credit Profile Is Exposed to Risk

As a co-signer, you put your credit on the line. First, you use your good credit to help the borrower qualify for the loan. But then you’re at the mercy of the borrower’s payment habits. If the borrower makes his/her payments on time, your credit score will benefit. However, if the borrower makes payments late or defaults altogether, it can cause your credit score to plunge.

If the debt is charged off or sent to collections, it can damage your credit score even further. But at that point, you’d become liable for the debt and might have to consider paying it to save your credit.

#5. You May Not Be Able to Remove Yourself as a Co-Signer

Co-signing a loan is a commitment. You can’t co-sign and after a few months remove yourself. You promised to be legally liable for the debt and in most cases, the only way off the loan is to refinance. In order for this to work, though, the borrower must be able to qualify on his/her own, which might not be an easy task at least right away.

What Are the Benefits of Co-Signing a Loan?

Despite the risks of being a co-signer, there are some benefits of cosigning a loan.

Most importantly, you’re helping a loved one or someone close to you get the credit they need. This is the number one reason anyone cosigns a loan, such as a parent co-signing for a child.

In a perfect world, if you co-sign on a loan and the borrower makes the payments on time and pays the loan off as agreed, you’ll build an even better credit score and feel-good knowing that you helped someone achieve their financial goals (and it costs you nothing).

>> More: How to Prequalify for a Personal Loan

Can You Build Credit Co-Signing a Loan?

You can build credit by co-signing a loan, but the effects may be minimal if you already have great credit. Most co-signers do it because they have outstanding credit and can help the borrower.

In the event that your credit has room for improvement, a timely payment history and paying the loan as agreed can boost your credit score. In addition, if it’s a loan type you don’t have and it improves your credit mix, it could boost your credit score slightly.

How to Protect Your Credit When Co-Signing a Loan

Protecting your credit when co-signing a loan should be your number one goal. Make yourself as involved as possible in the process.

Talk to the lender to find out how and when you’ll be notified if the borrower falls behind on his/her payments. Also, create an agreement with the borrower regarding payments and how you’ll handle it if/when they can’t afford them.

Put everything in writing upfront so everyone is on the same page, and you minimize the risks to your credit score.

>> More: Differences Between Co-Borrower and Co-Signer

Tips for Co-Signing a Loan

Before you co-sign a loan, consider these important tips:

  • Set expectations up front – Don’t assume you and the borrower are on the same page. Spell the terms out in writing and have everyone sign it so everyone understands.
  • Make sure the lender will communicate with you about the loan status or that you have the right to check up on the status.
  • Have money ready to make the payments if the borrower defaults. Don’t let a payment slip, but also have a backup plan should the borrower be unable to take over the loan payments again (sell the house or car, for example).
  • Know when you can get out. Most loans require the borrower to refinance to get out of the loan, but some have agreements that after a certain amount of time you can take yourself off the loan. Know the terms and make sure you’re okay with them.

Do All Lenders Accept Co-Signers?

Unfortunately, not all lenders allow co-signers. Mortgagesand personal loans are the two most common loans that are hit or miss when it comes to co-signers. Here are a select few lenders that offer co-signed loans: 

Always ask before applying.

Alternatives to Co-Signing a Loan

Co-signing a loan isn’t the only option borrowers have. Here are some alternatives to consider.

#1. Bad Credit Loans

Borrowers don’t need perfect credit for every loan. In particular, there are options for bad credit loans and the terms aren’t as bad as you’d think. Have your borrower exhaust all options before you agree to co-sign to see if there is an affordable solution.

#2. Credit-Building Loans

If a borrower doesn’t have enough credit, a credit builder loan can help. It’s not a traditional loan, though. The borrower takes out the ‘loan’ but instead of receiving the proceeds, they go into an escrow account and earn interest.

The borrower makes payments like a normal loan, and they get reported to the credit bureau. At the end of the term, the borrower receives the funds and hopefully has an improved credit score.

#3. Borrow Money from Your Family or Friends

If the borrower only needs a small amount of money, borrowing money from friends or family may be better. It could even be an alternative you consider rather than co-signing a loan. You can still have loan terms in writing, but you won’t put your credit on the line.

#4. Credit Cards (Be Careful!)

Credit cards can be an option, but one borrowers should be careful with because they can hurt their credit. Cash advances on a credit card are usually very expensive, so avoid them.

But using a credit card for a large purchase, such as home renovations, a medical emergency, or even an inexpensive car can be an option, but only if the borrower will spend less than 30% of his/her credit line or it will hurt their credit even further.

#5. Offer Collateral

Sometimes borrowers need collateral rather than a co-signer. Putting up collateral (an asset) gives the lender something to fall back on if the borrower defaults. It’s like the guarantee you’d provide as a co-signer, only you don’t have to put your credit at risk of the borrower puts up collateral.

Bottom Line: Co-Signing a Loan

Co-sign a loan with caution. Is it a nice thing to do? Yes, but it can be risky. Know the ins and outs of cosigning a loan and what risks you’re taking. Talk at length with the borrower and make sure he/she isn’t taking out more than they can afford, therefore putting your credit at risk.

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Kim Pinnelli
Kim Pinnelli

Kim Pinnelli is a Senior Writer, Editor, & Product Analyst with a Bachelor’s Degree in Finance from the University of Illinois at Chicago. She has been a professional financial writer for over 15 years, and has appeared in a myriad of industry leading financial media outlets. Leveraging her personal experience, Kim is committed to helping people take charge of their personal finances and make simple financial decisions.