How to protect yourself when cosigning a loan
According to some money experts, under no circumstances should you cosign a loan. It doesn't matter if it's a loan for your child, your brother or your best friend.
Cosigning can help someone establish a credit history, but it can also hurt your credit in the long run. Granted, cosigning doesn’t always end terribly. Some people have a positive experience. If the primary signer makes every single payment on time, cosigning can give both credit scores a boost. But there are no guarantees.
Ultimately, you have to decide whether to cosign a loan for another person. If you don’t have an issue with this arrangement and you trust the person, make sure you protect yourself.
1. Can you afford to make the payment on your own?
Cosigners usually have no intentions of ever making a loan payment, but it can happen. Again, there are no guarantees that a primary signer will make on-time payments for the duration of the loan term. It’s only smart to consider the worst-case scenario.
If this person loses his job or can't make payments for another reason, can you realistically afford to assume responsibility for the loan? Since you're the cosigner, the lender will contact you if the primary signer disappears or doesn’t make the payment. If you don’t assume responsibility for the debt, the loan may default and this action has a damaging effect on your credit score.
2. Do you plan on applying for your own financing?
Cosigning a loan for someone also increases your debt-to-income ratio. This ratio calculates the percentage of your income that goes to monthly debt payments. This is where cosigning gets a bit tricky. On one hand, you may never make a single loan payment. But on the other hand, this loan appears on your credit report and counts towards your debt-to-income ratio.
Unfortunately, too much debt can reduce your purchasing power when you're ready to apply for a loan of your own. As a result, you may qualify for a smaller mortgage or auto loan. Before you cosign, consider the impact this will have on your ability to get future financing.
3. Get a life insurance policy
If you’re cosigning a loan, consider taking out a life insurance policy on the primary signer. Depending on the loan, you may be liable for the debt is the primary signer dies. If you have a life insurance policy on this person—and you’re listed as the beneficiary—you can use the death benefit to pay off the loan.
4. Monitor the account
As the cosigner, you have every right to monitor the loan activity. If the primary signer manages the account online, ask for the login information. This way, you can sign into the account from time to time and check the status of payments. Since your name appears on the loan, you can also call the bank to check the status of the account. Keeping yourself in the loop helps you identify payment problems before a situation gets out of hand.