"For the person getting a co-signer, it serves a great purpose. It allows them to use someone else's credit standing to mitigate the risk for the [lender, so] they can get the loan, a better interest rate, or better terms," says David Pommerehn, the assistant vice president and senior counsel at Consumer Bankers Association.
For those who co-sign for a loan, however, the risks are plentiful.
Because co-signers will be responsible for the entire amount of the loan if the borrower defaults, Greg McBride, a CFA and senior financial analyst at Bankrate.com, has this blunt advice for people considering acting as co-signer: "Don't co-sign for any loan that you're not prepared to take on the responsibility of paying."
It's Hard to Say No Sometimes
It's not just parents co-signing for children or spouses signing for each other. Anyone can enter into a co-signing agreement, even an unwise one.
Many people may want to co-sign for a loan simply to help out a friend, whether or not that friend is fiscally trustworthy. But financial issues can cause strain in any relationship, and co-signing requests can be especially dicey. It might be easier just to give in and sign for a loan to keep the peace.
But, McBride warns, such concessions can have longer, less peaceful consequences. "If your motivation is to save the relationship or friendship, then say no to co-signing," McBride says. "This rift will be smaller than if the borrower sticks you with the bill."
When considering whether or not to co-sign, individuals should factor in how long and how well they've known the potential borrower, Pommerehn says. "Is this somebody you know and trust? Do you know their spending habits? Do you know their financial acumen? ... You're legally bound regardless of the relationship. I could meet someone and a year later co-sign for a loan and they could skip town."
He reminds co-signers that in the event that the borrower reneges, "It's your debt, for all intents and purposes, as far as bankruptcy."
Pommerehn suggests obtaining copies of financial statements, tax returns, or a financial plan for paying back the loan before signing. "Depending on the person, it may seem like a heavy thing to ask, but you're really putting yourself out there."
McBride suggests the co-signer monitor his or her financial statements, both before and during the loan.
"Keep regular tabs on the account status, either via online access or from receiving copies of statements," McBride says. "If the borrower falls behind, you don't want to be the last to find out." McBride also recommends the co-signer monitor his or her own credit report to see how the loan is being reported.
There Can Be a Happy Ending
In many cases, co-signed loans are paid back by the borrowers on a regular schedule, and the co-signers are barely affected.
"If they do everything correctly, and nothing catastrophic happens and they pay the loan back, everything's fine," Pommerehn says. "If they repay on the terms of the loan and close it out, it can improve their credit score, depending on the type of loan, and the borrower might not need a co-signer again."