Lenders use credit checks to determine if you have a history of repaying your debts on time. If your score isn’t high enough, a lender might request you add a cosigner to your application. But what happens when you have a high credit score and a loved one asks you to help them out and cosign for a loan or credit card? Learn about the risks of cosigning to better understand how it can affect your credit profile.
What Is Cosigning?
When you cosign a credit card, loan or rental application, you’re agreeing to be responsible for the other person’s debt. For example, if you cosign for a $10,000 loan, the lender can come after you in court if the applicant doesn’t make payments as agreed.
Landlords, banks and credit card issuers typically require a cosigner when an applicant has a poor credit score. A loved one may also need a cosigner if they don’t earn enough income to qualify for a loan or a rental.
Cosigning Risks: The Potential Impact of Cosigning on Your Credit
The biggest risk of cosigning is that the other borrower won’t pay back the debt. If this happens, you can expect the lender or landlord to contact you repeatedly. You’ll have to make payments yourself unless you want the other party to sue you.
Higher Debt-to-Income Ratio
Even if the other person pays their debt as agreed, cosigning can still have a negative impact on your credit profile. For example, if you cosign for a credit card, the issuer will report the balance owed to the major credit bureaus each month. If your loved one uses the card responsibly, this doesn’t pose much of a problem. If they rack up debt quickly, however, your credit report will show a large balance.
Your credit card balances are an important component of your debt-to-income ratio, which compares your monthly debt payments to your monthly gross income. If you have $1,000 in debt and $5,000 in gross income each month, your DTI is 20%. Now, imagine that your loved one makes $2,500 worth of new purchases. Once your debt increases to $3,500, your DTI increases to 70%.
A high DTI may prevent you from qualifying for a mortgage, forcing you to stay put in your rental until your loved one makes a dent in their credit card balance. If you have to move right away, you may have to pay the debt for them, leaving you with less money on hand for other expenses.
Changes to Your Credit Mix and Length of Credit History
Each FICO scoring model uses five factors to determine your credit scores: payment history, amounts owed, length of credit history, new credit and credit mix. Cosigning on a credit application can potentially affect your credit mix and the length of your credit history.
Credit mix refers to your different types of credit accounts, such as personal loans, auto loans and credit cards. Cosigning on a new account changes your credit mix, which may temporarily cause your credit scores to drop.
When determining the length of your credit history, each scoring model considers your average age of accounts. When you open a new account, the average age of your accounts drops. In some cases, this causes your credit score to decrease accordingly.
Over time, the negative effects of cosigning have less of an impact on your credit score, but you still need to think about how taking responsibility for someone else’s debt is likely to affect your credit.
Tips for Reducing the Risk
Once you know the major cosigning risks, it’s important to avoid them. One of the best ways to prevent damage to your credit profile is to insist that your loved one give you access to their online loan or credit card account. Online access makes it possible to log in and confirm that the other person has made their monthly payment on time. If they haven’t made a payment, you can make it yourself before the lender reports a late payment to one of the credit bureaus.
If you cosigned a lease, ask your loved one to give you their monthly rent money a few days before the official due date. You can deposit the money in your bank account and then use it to pay the landlord. Doing this reduces the risk that you’ll be blindsided by a sudden drop in your credit scores due to a missed rent payment.
Alternatives to Cosigning
Cosigning isn’t for everyone. If you’re not willing to risk your credit score to help out a loved one, there are some alternatives. First, ask the other person to apply for a secured loan or credit card. Secured credit products require a deposit, so they’re easier to get.
Another option is to suggest that your loved one search for loans specifically for people with bad credit. Bad credit loans are known to have higher interest rates and fees, but they’re a viable alternative to loans requiring a cosigner.
If your loved one needs a small amount of money, you can even agree to give them an interest-free loan. Just be sure to get the loan terms in writing before you hand over the money.Y
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