A friend or family member asks you to cosign a loan to help them get approved. You agree but aren’t quite sure what it means. Read on to learn how cosigning works and the ways it can impact your credit.
What is Cosigning?
Cosigning involves signing a loan or credit card agreement jointly with another individual. You’re assuming responsibility for the debt if the primary borrower is unable to make payments.
This practice is common among borrowers who cannot get approved for credit products due to limited credit history or a blemished credit score. Some individuals also bring cosigners on board when applying for credit to access more attractive financing terms.
How Does Cosigning for a Loan Work?
Ideally, the cosigner should have good or excellent credit and sufficient income to increase the chances of loan approval.
To illustrate how the process works, assume your cousin, Cindy, is seeking a personal loan. She’s searched all over for the best deals and found several options. Still, there’s only one problem – Cindy can’t qualify for a loan on her own. Her subpar credit scores and limited income are standing in the way, and lenders aren’t willing to take a risk.
Cindy can either settle for a subprime personal loan with rates through the roof. Or she can get a cosigner and potentially qualify for one of the loans she initially found.
She chooses to do the latter, and you agree to cosign to lend a helping hand. When Cindy sits down to apply, she must also enter your personal and financial information. The lender will also want your supporting income documents to confirm you have the means to make the loan payments in the unfortunate event Cindy is unable to.
How Cosigning a Loan Can Affect Your Credit
When you cosign a loan, the lender will check your credit to gauge your creditworthiness before making a lending decision. The hard credit check you’ll undergo could drop your credit score by a few points, but the impact is only temporary and lessens over time.
If the loan application is approved, there are other ways cosigning can impact your credit. For example, the way the borrower manages the loan determines if it will hurt or help your credit score.
When Cosigning a Loan Can Hurt Your Credit
Here are some potential negative effects of cosigning:
Loan Adds to Your Total Debt
The loan is reported on the primary borrower and cosigner’s credit reports. Even if you aren’t directly making the loan payments, the amount owed is added to your current debt load.
Missed or Late Payments
Payment history is the most significant component of the credit-scoring equation. So, just one missed payment can hurt your credit score. Luckily, adverse credit reporting won’t happen until the account is 30 or more days past due, giving the primary borrower time to get caught up. Late payments are reported for up to seven years.
Account is Sent to Collections
Once a loan is past-due for an extended period, it is sent to collections. The late payments will continue to pile up on your credit report. And if the lender sells the debt to an outside collection agency, it’ll also be reported as a collection account and could severely damage your credit score. Both late payments and collection accounts remain on your credit report for up to seven years.
Loaned Vehicle/Property is Repossessed
If you cosigned an auto loan or mortgage, failure to make payments could have serious consequences for your credit health. Depending on the severity of the delinquency, the vehicle could be repossessed, or the home could be foreclosed. Both can tank your credit score and also linger on your credit report for up to seven years, possibly preventing you from accessing loan products for years to come.
When Cosigning a Loan Can Improve Your Credit
Cosigning can also be beneficial in these situations:
Payments are Paid on Time
As mentioned above, payment history holds significant weight in the credit-scoring equation. So, timely payments can help improve your credit health.
Loans are Paid Off as Stipulated
Paying off the loan in the agreed-upon term demonstrates to future creditors and lenders you can responsibly manage debt. It could also make them more open to doing business with you.
The New Account Adds to Your Credit Mix
Credit mix makes up 10 percent of your credit score. Lenders and creditors want reassurance that you can manage both revolving (i.e., credit cards) and installment (i.e., personal loans, auto loans, mortgages) accounts.
Other Risks of Cosigning a Loan
Beyond the potential negative credit impact, there are other risks associated with cosigning a loan:
- You can’t get rid of the loan if the primary borrower disappears. In other words, the loan follows you even if the borrower decides they no longer want any parts of it.
- You’re legally responsible for the debt and can be sued in a court of law for failing to repay what’s owed. You’ll also be on the hook for any legal fees and court costs associated with the case.
- You could have trouble applying for loans. If the loan is irresponsibly managed, you may not be able to qualify for loans in the near future. The same applies if the loan payments leave you with a steep debt-to-income ratio.
- You could tarnish a valuable relationship. When you cosign for a friend or relative, you risk ruining the relationship if they stop paying on time and a disagreement happens.
Improve Your Credit Without the Risks
There are several ways to improve your credit that don’t involve the risks associated with consigning. Some ideas to get you started:
- Pay all your bills on time and bring any past due accounts current to prevent late payments from dinging your credit profile
- Reduce the balances on your revolving accounts to improve your credit utilization rate to 30 percent or lower
- Only apply for new credit as needed to minimize the number of hard inquiries appearing on your credit report
- Don’t close old credit accounts to preserve your credit age
- Maintain a healthy mix of revolving and installment accounts to demonstrate to future creditors you can responsibly manage different types of accounts
It’s also important to keep tabs on your credit while working to improve it. Consider signing up for a free Experian account to access free credit monitoring and several other useful features, including:
- Experian credit report monitoring
- Monthly Experian credit report and FICO score updates
- Experian FICO score tracking and alerts
- Personalized credit card and loan recommendations with Experian CreditMatch
- Experian Boost lets you improve your FICO score based on Experian data in real-time with alternative credit data
- Experian Go to help you establish and build credit from the ground up
Visit Experian.com to get started or explore other offerings available to you. It takes just a few minutes of your time to sign up, and a credit card isn’t required to create a free account and view your Experian credit report and FICO score based on Experian data.
