Don’t become a personal loan cosigner until you’ve answered these 10 important questions. (iStock)
When your credit score or income is low or you’re just starting out, a bank or credit union may require that you have a cosigner to take out a personal loan. It's their way of protecting their risk by getting a guarantee. If you’re the person a family member or friend asks to be the personal loan cosigner, however, you need to tread lightly.
While it can be personally satisfying to help someone else—especially someone in financial need—there are several downsides. Your credit score can be negatively impacted if the borrower doesn’t make their payments on time. You could be denied credit if the loan puts your debt-to-income ratio too high. And you could be forced to pay the loan if the borrower defaults or dies.
Before you become a personal loan cosigner, ask the primary borrower (and yourself) these 10 questions.
1. Why is the lender requiring a cosigner?
If the primary borrower is young and hasn’t yet built a credit history, a lender will often ask that they get a consigner as a guarantee. If you know the person is responsible, you may consider being a consigner. But if the borrower has a low credit score due to poorly managing their finances in the past, consider this to be a red flag. Is their money trouble in the recent past? Have they filed bankruptcy or been through an eviction? You need to know why the institution refuses to take a risk before you step up and take it for them.
2. What is the purpose of the loan?
Borrowers take out personal loans for a variety of reasons. Sometimes they need a vehicle to get to and from work or they need a down payment on a place to live. These could be solid reasons. If a borrower wants money to pay for a dream vacation or an expensive boat, however, you might not want to proceed. By knowing why they need the money, you can better assess their financial judgment.
3. What is the loan amount?
If the debtor doesn’t pay back the loan, a consigner is responsible for it. Knowing the amount of the loan can help you make a decision. If it’s small, such as $1,000, your risk is reduced. But if the borrower is looking for something large, like a $100,000 personal loan, you could be out a large amount of money if they don’t pay. Also be sure to understand the terms of the loan, such as the length and the annual percentage rate. If you have to assume the payments, you’ll want to know what you’re in for.
4. How do you plan to repay the loan?
Ask the primary borrower how they plan to repay the debt—exactly. You’re entitled learn where the money will come from, how secure the source of income is, and what they will do if their plan falls through. Also, find out what other expenses they have and how the loan repayment fits into their budget. And consider asking if the borrower has enough life insurance in place to pay off the loan in the unfortunate event that they die. If not, you could require that they take out a new policy to cover the term of the loan.
5. How will I stay up-to-date on the loan repayment plan?
In some cases, you won’t know that the borrower has missed payments until the loan goes into collection and negatively affected your credit score. Request that you’re added to communications from the lender. Get login information to check the loan online. And tell the borrower to update you immediately you if they experience unexpected financial hardship.
6. Does the lender offer a personal loan cosigner release?
In some cases, lenders will release a cosigner after a set amount of time as long as the primary borrower has proven that they pay the loan on time. Ask for the borrower to get a loan that offers this feature for you.
7. What are some alternative ways you could raise the money?
If the loan required a cosigner, find out if the borrower has explored other lenders or options for raising the money. Perhaps they can sell some of their personal belongings? Or they could get a part-time job? You want to be sure they didn’t take the easier route in getting a cosigner.
You’ll also need to ask yourself some questions.
8. Is my credit history healthy enough to handle this addition to my score?
Cosigning a loan increases your personal debt load and it will show up on your credit report. If you were planning on taking out a loan of your own in the near future, you could put your chances of being approved at risk if the cosigned loan balance raises your debt-to-income ratio too high or if the borrower makes late payments that lower your credit score.
9. Can I afford to pay the debt?
Even if the borrower is responsible and has a good way to repay the loan, situations could arise that change the best-laid plans. Don’t cosign a loan if you can’t afford to make the payments or pay off the debt. Assume the worse case and hope for the best.
10. What does my gut say?
If the person has demonstrated that they’re not financially responsible in the past or if they have a track record of reneging on promises, trust your instincts. While you may want to give the person the benefit of the doubt, you probably have an idea about whether this will end well.
Don’t be afraid to say “no.” It may be better to disappoint someone now than to have to deal with the fall out to your finances and your relationship if the person defaults on the loan. Trust your gut and you’ll avoid asking this question: "What was I thinking?"