Managing your personal finances well often comes down to how you respond to certain situations. This can include knowing when to leave the plastic in your wallet and pay cash or when to make changes to your investment portfolio. You may have to make tough decisions in how much car or house you can afford. You will probably make thousands of decisions in your lifetime that directly affect your financial future.
One of the most difficult decisions to make is choosing whether or not to lend money to family or friends, or whether or not to co-sign a loan for them. Like all the other choices you have to make, your decision here will have an impact on your personal finances. Before you reach for your wallet or grab a pen and sign the loan, you should understand exactly what is being asked of you as well as your responsibilities.
What does it mean to “co-sign”?
If you have been approached by someone you know to co-sign a loan, your first reaction may be a desire to help them out in tough times. While your signature may make the difference between them being approved for or denied a loan, you must understand what you are agreeing to when you sign your name as a co-signer. The co-signer of a loan is basically the guarantor. This means the first signer on the loan did not have enough credit or had poor credit which made them unable to qualify on their own. Using your name and credit as a co-signer gives the lender someone to fall back on should your friend or family member default on the loan. In a nutshell, a co-signer agrees to all of the terms and conditions of the loan, including repayment if the original signer is unable or unwilling to do so.
Dangers of co-signing a loan
1. It reduces your ability to borrow
Since you are basically on the hook for the co-signed loan until it is paid off, you reduce your own ability to borrow. This could be damaging if you find yourself in a situation where you need to take out a loan.
2. Your credit score is affected.
When you co-sign for a loan you increase your own debt-to-income ratio which may result in a hit on your credit score. The debt to income ratio increase is actually the best case scenario; should your friend or family member miss a payment or make a payment late, that too will be reflected on your credit score.
3. The loan could default.
At the end of the day, the biggest danger of co-signing is having to repay the loan if it goes into default. If you are unable to repay the loan, you will suffer the same consequences as the original signer, including collection efforts and possibly legal action taken against you.
Before you agree to co-sign a loan for someone close to you, think not only of the financial risks but also the risk to your relationship. Should the worst case scenario come to fruition and you end up paying off a loan that was intended for your friend, the relationship will surely suffer. This could prove to be more costly than the damage to your finances.
Have you co-signed a loan before? Tell us what happened!