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Co-signing a loan: Risks and benefits

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Being asked to co-sign a loan can put you in a difficult situation. On one hand, you want to help the person, but on the other hand, you are wary of the risks. So how can you weigh the risks and benefits to make a decision that benefits both parties? While there’s no straightforward solution to this situation, you need to be aware of the risks and the benefits of co-signing a loan before you sign on the dotted line. Here’s everything you need to know: 

 

What Is a Co-Signer?

A co-signer adds their name to a loan agreement and becomes legally responsible for paying back the loan if the primary borrower cannot do so. This differs from a co-applicant where both signers are applying to use the funds. When you co-sign a loan, you have no access to the funds but could be responsible for repaying them. People generally co-sign loans for close friends or family members that they have a strong personal relationship with, for example, a spouse, child, or even parent. 

 

When Are Co-Signers Necessary?

Obviously, this doesn’t sound like a very beneficial agreement. So when are co-signers necessary in the first place? Generally speaking, co-signers become necessary when a borrower is unable to qualify for a loan on their own. This could be due to bad credit or a short credit history. It could also be due to a lack of income or overall funds. It could be necessary if the person is self-employed and doesn’t have the required documentation to qualify independently. A co-signer with a robust and substantial credit history and income may be necessary to qualify in these cases. 

 

Risks of Co-Signing a Loan

Before you co-sign a loan for someone, it’s essential to know the risks involved in this venture. Here are some of the risks of co-signing a loan to consider:

  • Credit: Co-signing a loan for someone could affect your short-term and long-term credit. In the short term, the loan application will show up on your credit report, and your score will likely decrease. In the long-term, your credit could take a hit if the primary borrower is unable to repay the loan. 
  • Financial: Co-signing a loan is a financial risk wherein you could become responsible for paying back the loan if the primary borrower cannot make payments. Consider if you could afford to pay the overall amount and the monthly payments on your own. Alternatively, putting your name on this loan could affect your ability to take out additional loans in the future. 
  • Relationship: Co-signing a loan could also take a toll on your relationship with the primary borrower. Money and family should only be mixed with a great deal of caution. It’s difficult to predict 

 

Benefits of Co-Signing a Loan

In addition to the risks, there are also benefits of co-signing a loan to consider. Obviously, the most significant advantage is that you help a close friend or family member secure financing for something important like a house, car, or even their education. You could also help them get a lower interest rate on the loan as a result of your strong credit history and consistent employment history. Finally, you can help the primary borrower build and establish their credit history by taking on a loan and making consistent payments. 

 

Should You Co-Sign a Loan?

Clearly, there are a lot of risks to co-signing a loan for someone. As a result, you’re going to need to examine the benefits of co-signing and possible alternatives to decide what’s best for your unique personal and financial situations. It’s not an easy decision, but here are a few considerations to help you come to one:

  • You can afford it: You should only co-sign a loan if you can genuinely afford to pay it back. If paying it back on your own would put you in a difficult financial position, you probably shouldn’t co-sign the loan.
  • You have a solid relationship: Co-signing a loan is a serious venture that will link you and the primary borrower for years to come. For this reason, you should only co-sign a loan for someone you completely trust. They should also be honest and financially responsible. 
  • You want to help: Co-signing a loan can be a huge help to friends and family members who may be in a tough spot financially. Odds are that you care about this person and want to help them out. That being said, keep in mind that in this case, helping them out places a significant burden on you. 

 

Alternatives to Co-Signing a Loan

While you may think that co-signing a loan is the only option for your friend or family member to get the money they need, there could be alternative solutions that would be less of a burden and a risk to you. Here are some alternatives to co-signing a loan to consider: 

  • If you’re co-signing something like a home or auto loan that requires a down payment, consider helping the borrower with this expense so that they can more easily afford the payments necessary to qualify for the loan on their own. This can either be a gift or a private loan — just make sure that all terms and conditions are clear with both parties. 
  • Another alternative to co-signing a loan involves bridge loans, such as those offered at Vaster Capital. A bridge loan is a short-term loan used to provide money quickly while you wait for permanent financing. Requirements for credit scores and employment history are less strict when applying for a bridge loan, although providers will check for prior credit delinquencies. Interest rates are slightly higher for bridge loans but lower than rates for hard money loans. Bridge loans are best for local real estate investors, developers, and large corporations looking to finance investment properties. 

If you aren’t comfortable helping out your friend or family member financially, you could offer them tips and advice to help them secure funding on their own. Here are some potential avenues to consider:

  • Use collateral: Some lenders allow borrowers to sign over assets as collateral in the event that they cannot repay the loan. Some examples of collateral include cars, homes, or even investment accounts. 
  • Check out alternative lenders: Big banks aren’t the only lending option out there. In fact, some alternative lenders offer more flexible requirements. As a result, your friend or family member could be able to qualify for a loan on their own in exchange for higher interest rates. 
  • Research federal loan options: If your friend or family member wants you to co-sign on their home purchase, there are tons of federal loan programs out there that could help them qualify on their own. These programs are designed to help those with less-than-stellar credit histories, short credit histories, and low cash reserves purchase a home thanks to lower credit requirements and lower down payments. Many people aren’t even aware that such programs exist, so it’s definitely worth mentioning. 
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How to Mitigate the Risks of Being a Co-Signer

If you have decided to co-sign a loan, there are things you can do to mitigate some of the risks that come with co-signing a loan. Before you sign on the dotted line, here are some things you should do:

  • Establish a private agreement with the primary borrower that delineates expectations, terms, and conditions to keep everyone on the same page. Such an agreement differs from the primary lending agreement and doesn’t necessarily have to be legally binding -- however, it often helps to simply put things on paper.
  • Obtain copies of all loan paperwork, thoroughly read, and understand them. Store these copies in a safe place that you can easily access if you need more information about terms and conditions at a later date. 
  • Gain and maintain access to the online loan account so that you can monitor payments and make sure that the primary borrower is keeping up their end of the bargain. Continuously monitor this account to avoid any missed payments that may damage your credit. 
  • Communicate regularly with the primary borrower. Establish a system of open communication -- it’s better to know about issues ahead of time so that you can address them before it’s too late. 
  • Be proactive and set money aside to cover the loan payments if the primary borrower is unable to pay. Again, it’s better to be prepared and have the money you need to keep the loan in a favorable status than to be caught off guard and be unable to make up those payments. 

 

Final Thoughts on Co-Signing

As you can see, there are both risks and benefits to contemplate when you’re considering co-signing a loan. And while the risks generally outweigh the benefits, you shouldn’t underestimate the value of helping out a loved one in need. So if you do decide to co-sign a loan, make sure that you take all the necessary steps and use a trusted lender like Vaster Capital to mitigate these risks and preserve your credit in the process. 

 

Sources:

How to build credit and achieve a good credit score | CNBC.com

Loan Agreements With Family And Friends | Debt.org

Let FHA Loans Help You | HUD.gov