You want to help a friend or family member with their loan, but will co-signing affect your credit score? Technically, it can, but more realistically, it probably will.
We all have friends and relatives who are always on the edge, needing you to rescue them. They call you late at night, needing a ride or someone to bail them out. They borrow money and promise to pay you back but you never see a nickel from them. You wish you could just cut them loose, but it can be hard to do, especially with family.
Someone who asks you to co-sign a loan for them may even put pressure on you when you tell them no. Should you give in? What could happen?
How does cosigning affect the credit score you’ve worked so hard to build?
What Co-signing a Loan Means
Co-signing a loan means you legally promise to pay the debt if the borrower does not. So, for instance, if your little brother has bad credit and can’t get a car loan, but he has a good job and enough money to make car payments, he may ask you to co-sign the loan for him. Maybe he got crazy in college with a credit card and ran up a balance and couldn’t make the payments. The bank doesn’t want to lend him the money because they think he is a bad risk. But you know that was a few years ago, and he’s more responsible now.
So what’s the worst that could happen, right? If he doesn’t make the payments on time — even just once — this can affect your credit score. Credit reporting agencies don’t differentiate borrowers and co-signers. You are responsible for the debt, regardless of your status on the loan document.
However, while you hold responsibility for the debt, you will not usually be informed of a late payment, unless the borrower stops paying altogether. Then you can be sure you will hear from the bank.
So there is a lot of risk involved in co-signing a loan, and little benefit. It’s a huge favor to do, and you have to have a lot of trust in the person you’re co-signing for. And honestly, people who need co-signers usually need them because they’ve made financial errors in the past, so their integrity is already dubious.
Co-signing a Loan Stays with You for Years
Even if he makes all the payments on time, the debt is still on your credit history until it’s paid off. So if the loan is for $15,000, your credit report will show a $15,000 debt. This could count against you if you attempt to secure funding of your own for future purchases, such as a mortgage.
When you apply for a mortgage, it’s not just your credit score they look at, but your credit report. Your credit score shows how well you’re managing your finances, and your credit report lists your debts and payment history. The consumer credit reporting agency Experian explains that co-signing a loan can affect your credit by skewing your debt-to-income ratio.
Your credit report is used to figure your debt-to-income ratio. The Consumer Financial Protection Bureau explains that your debt-to-income ratio is calculated by the amount of your monthly debt divided by your monthly income.
Let’s say you make $3,000 a month and you pay $800 in rent, your car payment is $300 and your student loan payment is $200. That’s $1,300 a month in debt — 43 percent of your income. Most banks will not consider any mortgage candidates with a debt-to-income ratio higher than 43 percent. So if you co-sign a loan — in this case for any amount of money — you will push yourself into a higher percentage range, making it nearly impossible to get a mortgage. You won’t be able to change this ratio unless you start making more money, pay off another debt or move to a cheaper place.
Co-signing with a Partner who Becomes an Ex
Now let’s look at another scenario with potentially more dire consequences. Say you are in a relationship but not married and get a joint credit card, or co-sign for a credit card or loan. Then you break up. What happens with that debt?
Other consumer financial websites give you lots of options to protect your credit, like make the payments yourself or ask the person to take your name off the card. Clearly, no one on these sites has been through a real breakup. Either that or they’re delusional.
If your ex merely refrains from running up a bill and sticking you with it, count yourself lucky. Talking them into voluntarily releasing you from your obligation to pay their bills probably works just as often as asking nicely for a divorce and your life back. And paying their debt for them to save your credit is not an attractive option either.
If you co-sign a credit card with someone, you are responsible for the charges they make. If you change your mind later, the credit card company won’t let you take your name off the account. This is because they don’t think the cardholder is a good risk. If the cardholder has been making payments on time and in full, they may be able to qualify for a card in their own name. But if they don’t want to, you’re stuck.
This is the case even when you are married. The difference is that, generally speaking, marriage debt is split equally regardless of who incurs the debt or how it is incurred.
Strategies for Getting Out of Your Obligation
If you are a joint account holder, you have the power to close the account. But in order to do so, you will likely have to pay the debt first. A credit-card company will not let you close an account with a balance.
While paying this balance might seriously tick you off, what’s good about this option is that your ex will not be able to run up even more debt that you will also be responsible for.
Other strategies for getting out of a co-signing deal are:
- Try to get the borrower to transfer the balance to a zero-interest card that they can qualify for on their own, or try to get them to fold the debt into a consolidation loan.
- Try to convince the borrower to sell whatever they borrowed money for. This makes more sense if it is a car. If it’s a Caribbean vacation or a bunch of shoes, this probably isn’t an option.
- Get some other sucker to co-sign in your place. (Maybe the new girlfriend or boyfriend. Hurry, before they wise up.)
But what happens after all the dust settles? The debt may be paid, but your credit report has taken a beating.
How to Clean Up Bad Credit
Your credit score is a number between 300 and 850. The higher it is, the better the bankers like you. Experian says the average credit score is between 600 and 750; 700 is usually good enough for most loans, but higher is better.
Keep in mind that qualifying isn’t your only goal when you apply for a mortgage, credit card or other types of loans; the terms are also important. You might get so excited seeing the “approval” notice that you don’t see that your interest rates are the highest legally allowed.
Ironically, one of the ways Experian suggests you improve your credit score is to get someone to co-sign a loan for you! If nothing else, you’re familiar with how this is done.
The bottom line is you have to start showing creditors that you are responsible. You need your credit report to show that you make payments on time. If you don’t have a mortgage or a car loan, take out a loan and be careful to pay it back on time.
This will cost money, not just because you have to pay interest, but your interest will be higher because of your poor credit rating. But it’s the price you have to pay to clean up the mess.
If you have credit card balances, work on paying them off. Once this is done, try to pay them in full each month so you maintain a zero balance. This will favorably affect your credit score as well.
Also, try to limit the number of loans and credit cards you have. If you try to open, say, a department store account and you are rejected, this will negatively affect your score. Even if you are approved, the more inquiries into your credit history and the more open accounts you have — even if you don’t carry balances — all affect your credit score.
This is because it’s easier for a person who already has accounts open to run up a bill suddenly and overextend themselves than it is for someone who doesn’t even have many accounts open.
You can also get help cleaning up your credit. But don’t just go to any fly-by-night place; make sure they are lawyers and not hucksters setting up shop in cheap office space.
So as you can see, the best course of action to take when someone asks you to co-sign anything is just say ‘NO’. Husband, wife, SO, mom, dad, sis, bro, son, daughter, cousin, friend, ex, grandma, grandpa — nope. If it makes you feel bad, lend them the money they need, but don’t co-sign a loan. If you lend the money and they don’t pay it back, you’ll lose it, but if you co-sign a loan, you’ll lose the money AND your credit report will be damaged. If you don’t have the money to lend them, you aren’t really in a position to co-sign a loan either.
Co-signing does affect your credit, and usually in a negative way. Don’t do it.