Why Cosigning a Loan Is a Bad Idea

By Wendy Connick Markets Fool.com

When a friend or family member comes to you and asks you to cosign a loan for them, just say no. Cosigning a loan for someone is a really bad idea, no matter how sure you are that your child or your best friend would never run out and leave you with the consequences. If the lender requires a cosigner for a loan, it means that the lender is convinced that the borrower won't meet their obligations... and they're usually right.

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What you need to know about cosigning

Anyone who agrees to cosign a loan receives the following notice from the lender:

You are being asked to guarantee this debt. Think carefully before you do. If the borrower does not pay the debt, you will have to. Be sure you can afford to pay if you have to, and that you want to accept this responsibility. You may have to pay up to the full amount of the debt if the borrower does not pay. You may also have to pay late fees or collection costs, which increase this amount. The creditor can collect this debt from you without first trying to collect from the borrower.* The creditor can use the same collection methods against you that can be used against the borrower, including suing you or garnishing your wages. If this debt is ever in default, that fact may become a part of your credit record. This notice is not the contract that makes you liable for the debt.

*Note that certain states forbid lenders from collecting from the cosigner first; if you live in one of those states, this line will be crossed out or absent.To find out if your state has such a law, check the relevant site fromNolo's state law resources page.

Read through the above notice carefully and consider all the ramifications. Cosigning puts you in a "worst of both worlds" situation. You don't get the benefit of the house, car, student loan, etc. that you're guaranteeing, but if things go wrong you'll be responsible for paying for it! If the borrower defaults, you could be sued by the lender, you could have your paycheck garnished, and if things go really badly you could end up in bankruptcy court.

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Image source: Getty Images.

And while it's always tough refusing to help someone you care about, consider what will happen to your relationship with that person if they miss payments or flat-out default on the loan and you're stuck with the consequences. That will do a lot more damage to your relationship in the long term than if you just said no to cosigning to begin with.

What cosigning can do to your credit

If the borrower is late with a payment or skips one entirely, that will show up as a negative mark on your credit report. Even if the borrower is diligent about making the payments, you may still run into credit problems as a result of cosigning. Any loan you cosign will show up on your credit report as one of your own debts. That means that if you apply for a big loan for yourself, such as a mortgage, you may get turned down because it looks like you already have too much debt.

If despite all the above dire warnings you decide to go ahead and cosign a loan, then at least take steps to protect yourself. First, monitor the borrower to make sure that they're making their payments on time. This may entail calling them up every month a few days before the due date to remind them to make their payment on time. Yes, that's a hassle, but if this person can't get a loan without a cosigner, there's a good reason for it. They'll most likely need nudging at least a few times over the course of the loan to get the payments in on time. And if you just let the borrower do their thing until collections agents start calling you, your credit will already be damaged by that point (probably for years to come).

Second, you should assume that the borrower will not always be able to make the payments and you'll have make them on occasion. After you cosign the loan, open a new savings account and fund it with the equivalent of a year's worth of loan payments. That way, making those payments for the borrower won't make it impossible for you to cover your own expenses. And if the borrower up and disappears, you'll have a chunk of money that you can use to try and negotiate a settlement with the lender. Your credit will take a hit, but at least you won't be driven into bankruptcy.

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