As obtaining credit becomes increasingly difficult for young people, low-income workers, and those with poor credit scores—especially in the midst of a restricting economy and widespread layoffs—you may be faced with more requests to assist your family members by co-signing a loan.
Before you agree, understand the potential pitfalls to co-signing a loan. If your family member is unable or unwilling to make payments, you will be forced to either pay the loan yourself or have your own credit score suffer.
But if helping out someone who is important to you makes these risks worthwhile, and you decide to co-sign for someone, be sure to take the following steps to protect yourself.
Co-signing a Loan Rule #1: Read the contract carefully and ask questions. Be sure you know what will happen if the primary borrower defaults. Will the lender send you a notice of default, or will those go strictly to the primary borrower?
Co-Signing a Loan Rule #2: Track the payments. Ideally, you need to track the account online, receiving notices both when a payment is due and when one is received. Otherwise, you may not even know whether the primary borrower is paying on time. Another advantage to monitoring the account online is that you can make last-day payments if the primary borrower is late, ensuring that your credit score is not adversely affected and protecting the account from incurring late fees.
Co-Signing a Loan Rule #3: Consider paying the bill yourself and having the borrower cut you a reimbursement check. Of course, this comes with its own risks, but paying the bill yourself every month—and having the primary borrower reimburse you—puts you in control. You control the payment. This means that you will not suffer from bad credit should the borrower default. You will also prevent any late fees or penalties from accruing. An even bigger benefit is that the borrower is less likely to default if it means looking you in the eye and explaining why he is not handing you the monthly check.
Co-Signing a Loan Rule #4: Ask the borrower for collateral before agreeing to co-sign. This is not only a wise financial move, but it might also save your relationship. If the borrower defaults, at least you have some recourse.
Co-Signing a Loan Rule #5: Refinance as soon as possible. After a year of timely payments, contact the creditor and see if the loan can be refinanced in the primary borrower’s name only.
Co-Signing a Loan Rule #6: Ask the borrower to begin the process of learning how to build credit. Make it clear that you prefer to co-sign only once. If the borrower builds his or her own credit, you will not have to repeat the favor.
The long and short of it is this: Co-signing a loan is a risky move, no small favor to the primary borrower. That’s not to say you should never co-sign on a loan, but if you do, be sure you take as many actions possible to mitigate the risks.