Let’s say someone you know and love asks you to co-sign on a loan. Good choice or bad choice? The answer could be yes to both. When it comes to co-signing, it really depends on the parties involved.
When you co-sign, you are legally responsible for repayment of the debt so you’d better feel pretty comfortable with your decision. As a co-signer on a loan or credit card application, you're lending your good name and your solid credit history. You also make a promise to repay in full if the original borrower can't or just decides to stiff you. Also keep in mind these two things:
- Your credit score may change. The amount of the debt and any missed payments become part of your own credit history. A lower score might hurt you in applying for a future loan, resulting in a higher rate or even possibly rejection.
- If the borrower defaults, collectors may come to you for payment. Take, for example, a car loan where the borrower defaults. Even if the car is repossessed, you may have to pay, as its value may not be enough to cover the outstanding balance.
Now you’re probably thinking, “Is this ever a good choice??” You wouldn’t be considered a complete wacko if you co-signed for a loan because there are a lot of scenarios where this is the right thing to do. Let’s look at a few:
- Your 19 year-old has saved for a new car, has steady income and is responsible enough to handle making the loan payments. Of course at Abri, she would qualify for a driveIT loan but at most financial institutions she would probably get turned down because she has no credit history and would be considered a risk. Acting as a co-signer would get her in that car and more importantly, probably at a much better rate because of your good credit history.
- Your sister has been a stay-at-home mom for the past 20 years with no work history or credit cards in her name. She now gets divorced and needs to support herself. Although she lands a good job, she still can’t get a credit card because most lenders see her as too risky. By co-signing on her credit card, you can help her until she can establish her own credit.
If you decide to co-sign, here’s some great advice from Joanne Sepich/Home and Family Finance on how to make it work:
- Set up automatic payments.
The best way to build a strong credit history is to make every payment on time. Before you co-sign for a loan, insist on establishing automatic monthly payments. Although you can’t legally require it, pushing for this does protect your credit history and helps the borrower build one. The No. 1 factor in calculating a credit score is payment history, according to the Fair Isaac Corporation, creator of the widely used FICO score.
If you're co-signing for a credit card, consider automatic payments to cover 5% or more of the card limit ($25 on a $500 limit). This protects you both against a missed payment, which may alter the rate. The borrower can make additional payments every month to pay off the statement balance.
- Agree to limits.
Know when you're getting out before you get in. For a loan, aim for three years or less. If that's not practical, make it clear you'll act as a co-signer for just three years; then revisit the credit union to renegotiate the loan without your signature.
For a credit card, start with a low limit. Since debit cards are widely accepted, there's little need for a $5,000 credit limit. A thousand dollars, even $500, might be a good place to start. As a co-signing parent, you'll be notified of any request to raise the credit limit. And once your son or daughter reaches age 21, visit the credit union to remove your name from the account.
- Share payment notifications.
As a co-signer, you have the right to see statements and payment notifications. The easiest way may be through shared online access. This gives you the opportunity to step in before an accidentally missed payment turns into a past-due problem. Avoid the temptation, however, to criticize credit card purchases.