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Sharing the benefits of your good credit may seem like an easy favor to do for someone you care about. After all, credit isn’t a finite resource, right? Unfortunately, co-signing a loan carries significant risks to you, even if the main borrower behaves honorably. Here’s what you need to know before you consider doing someone this dangerous favor.
If you have plans to finance a car or take out a loan yourself in the near future, co-signing a loan for someone else narrows your own financial options. Lenders will add the amount of the co-signed loan onto your other debt, and they may decline your loan application because they feel your debt level is now too high.
Borrowers need you to co-sign a loan either because they have minimal credit history or because they have poor credit. In either case, that person probably doesn’t have a strong track record of making on-time monthly payments. Even one forgotten payment will damage your credit, so your responsibility for this loan doesn’t end with signing your name. Imagine the pressure it will put on your relationship with borrowers if you’re checking up on them every month for years on end to make sure every loan payment is made on time.
Many people assume that being a co-signer means that the lender will only contact you if the borrower completely defaults. What actually happens is that the lender goes straight for the person with better credit, and that’s you. If loan payments aren’t made, lenders may not even bother pursuing the official borrower; they will bring legal action against you first for 100 percent of the liability. You can then sue the borrower for one-half the amount of the loan, but that’s a messy and difficult transaction if it involves someone close to you.
If the co-signed loan goes into default, the lender may agree to settle the debt for less than the original amount. This has destructive effects on your credit, of course, but it can also cost you significant out-of-pocket cash for income tax. The lender notifies the IRS, which considers debt forgiveness to be income. On your next tax return, you’ll be expected to pay income tax on the settled amount.
Taking care of the people close to you is a good thing, but you can find many ways to provide financial support that are safer than co-signing a loan.