How does co-signing a loan work? 14.06.2021
Whether you’ve been asked to co-sign a loan or need someone to co-sign a loan, here are the complete details to know before making a move.
What does co-signing a loan mean?
In simple terms, co-signing a loan means three things. First, you’re helping someone get a loan. Second, you’ll be responsible for paying off the loan if the person you’re helping fails to pay it off. Last, although you’re responsible for the loan, you don’t get to share the borrowed funds or any underlying property.
Typically, co-signers are close family and friends, which makes sense because you’ll need someone you can trust when taking on such a risk. Most people are denied a loan because of a bad credit score. Whether that’s because of poor payment performance or insufficient credit history, having a co-signer with a good credit score helps turn the situation around.
Benefits of co-signing a loan
As mentioned earlier, co-signing a loan carries some risk, but first, let’s look at the brighter side of things.
You’re helping friends and family
It’s always a good day when you can give the people close to you a leg up. For instance, your help can be a game-changer or life-changer to a financially responsible young borrower who’s being denied a loan because they’re still in the process of building their credit score.
Or maybe it’s someone who needs to recover from a bad financial situation. They may need a loan for all sorts of worthwhile reasons, such as debt consolidation, buying a car, or paying for their education.
There’s a potential credit score boost
Both signers can increase their credit score if payments are made on time. While this is a nice perk for the co-signer, the primary borrower will appreciate it more if they were failing to qualify for the loan because of a poor credit score. The credit score boost means they’ll have a better chance of securing a loan without extra help in the future.
You get a better deal, overall
Co-signers use their good credit score to increase the chance of loan approval and secure better interest rates for their friends and family. Without this support, a person with a bad credit score and history will likely get a higher interest rate because of the risk they pose. In some cases, having a co-signer saves them from predatory lenders who charge excessive interest rates to desperate, bad credit borrowers.
Risks of co-signing a loan
When people raise the question of whether co-signing a loan is a good idea, it’s often because of the following reasons:
No financial benefit
This a glaring fault of co-signed loans. You’re taking on the risk, but there’s no material reward when the loan is approved. Instead, it’s the person you’re co-signing for who gets to drive the car or spend the money for whatever purpose they have in mind.
Potential for financial loss
Besides the lack of material benefit, you may also end up paying off a loan you didn’t use. That’s because when you co-sign a loan, you’re basically telling the lender you’ll be responsible for paying off the loan if the primary borrower defaults.
The lender will approve the loan on that basis alone, then hold you to your word if the situation calls for it.
Negative impact on future loan applications
A co-signed loan shows up on your credit report and increases your debt to income ratio. This may cause lenders to doubt your ability to service a new loan, particularly if it’s a large sum. So even if you think you may not need a loan down the line, your situation could change at any time. Then it would be your turn to get declined for a loan you really need.
In the worst-case scenario, if both you and the other signer fail to pay off the loan, your credit scores will take the hit. This not only affects your chances of loan approval but can also create other problems, such as dealing with debt collectors and court judgements.
No peace of mind
Having debt is something that easily stays at the back of your mind. Being a co-signer is slightly more worrisome because you won’t be in control of the other person’s behaviour. That means you’ll have to constantly check in with them to keep track of payments. You may even resort to saving some money aside just in case the primary borrower defaults.
Indeed, most people will only co-sign a loan for people they’re close to. But this can quickly change if there’s a disagreement over payments or if someone breaks their promise. Because discussing money issues can be uncomfortable, it’s easy for both signers to have different expectations if they avoid the topic. Therefore, when disappointment sets in, the relationship might be lost.
How to ask someone to co-sign your loan
With so many risks attached to co-signing a loan, it becomes tricky asking for this favour. However, there are things you can do to improve your approach.
- Explain your reasons for taking out the loan. It helps if you’re taking out the loan for a reason the co-signer can relate to. Also, if the co-signer is close to you, they’re more likely to empathize and help, despite the risks.
- Be honest about why you need a co-signer. If your bad credit score is a result of missed payments, you may be afraid that the potential co-signer won’t trust your ability to make future payments. However, the co-signer needs to know the risk level before committing. Otherwise, you might end up rocking the relationship boat.
- Discuss the risks and find a solution. Make sure that the co-signer knows they will be legally responsible for the loan. Next, face the issue of what would happen if you default head-on. In any case, it’s important to always be transparent and honest in your communication to avoid any nasty surprises for the co-signer.
Can you get your name off a co-signed loan?
Unfortunately, co-signing a loan may be easy, but reversing the process isn’t always as simple. That being said, here are some ways to have your name removed from a co-signed loan.
Ask to be removed
Sometimes, the terms and conditions of the loan may state that the co-signer can be excused once a specific number of on-time payments have been made. It’s best to review the loan terms before signing, so you know exactly what your options will be.
This only works if the primary borrower can now qualify for a new loan by themselves or if they’re switching to a different co-signer. Once the new loan is approved, the existing loan is paid off, and the account is closed.
Since your name is not on the new loan, it essentially means you’re free of co-signer obligations. Generally, most loans can be refinanced, including credit cards, personal loans, car loans, mortgages, and student loans.
Sell the financed property
If the primary borrower uses the money to purchase a tangible asset such as a car, you could ask them to sell it. If they’re unable to make payments, this ensures that they’re in a better position to completely pay off the loan, which means you’re no longer legally responsible for it.
Speed up the loan payments
Simply ask the person who receives the money to pay off the loan early by making extra payments. If you’re willing and able, you could also make contributions that speed up the process. The faster the loan is paid off, the quicker you can remove your name from the deal.
Co-signing vs. co-borrowing
Co-signing and co-borrowing are similar because they typically involve two people putting their name and signature on a loan. Also, these two people are both responsible for paying off the loan.
The main difference is that while a co-signer doesn’t have any right to the loan or any underlying assets, the co-borrower gets to share the funds and has rights to any property purchased by the loan.
Are there alternatives to co-signed loans?
If getting a co-signed loan proves to be difficult, there are some options you can still explore.
- Work on building your credit score. Keep in mind that this may require you to wait until your credit score is up to par. Common remedies for a bad credit score include fixing credit report errors, paying off debt, and sticking to payment deadlines for existing loans.
- Opt for a secured loan. If you offer collateral, such as your car or home, the lender will have something to sell to recover their money if you default. This increases your chances of getting a yes to your application.
- Take out a bad credit loan. You may have better luck with a lender that specialises in bad credit loans. However, you should note that this may mean getting a higher interest rate than average.
- Make a down payment or borrow less. You can borrow money for a down payment from your family and friends instead of asking them to co-sign your loan. Or you could opt for a cheaper option, so you don’t have to borrow as much. This increases both the loan’s affordability and your chances of approval.
The bottom line
Co-signing a loan is a viable option if you want to help another person qualify for a loan. However, there are many crucial factors to consider for both the co-signer and co-signee. Therefore, it’s essential to review the main points mentioned above and carry out additional research (depending on the type of co-signed loan) to ensure both parties make the best decision for themselves before accepting the loan offer.
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