What is co-signing a loan and how does it impact your credit score?

Co-signing is often considered a show of trust and support in the personal finance world, but the shared liability that comes with that goodwill can have long lasting consequences on your credit health.

Understanding co-signing

When you co-sign, you are committing to pay the loan or line of credit should the principal borrower default. This help for someone else can ultimately be of benefit to those with weak or limited credit history. But from the lender's perspective, you bear the same risk even though the borrower gets the actual money or credit.

How does co-signing affect your credit score?

When you co-sign a loan or credit account, it appears on your credit report as if you are the borrower. Your timely or late payments on that account directly affect your credit score.

By repaying a well-managed loan on time, your profile could be improved demonstrating to lenders that you are responsible with shared financial obligations. Conversely, if the account has any default, late fees, or over-limit usage, you will pay the price even though you are not the actual user.

What happens if the borrower defaults?

1. If the primary borrower defaults or misses payments, the lender will pursue you, the co-signer, in repayment.
2. Your credit score is negatively impacted from missed payments when both you and the primary borrower miss payments, as it is noted by the credit bureaus under both names.
3. Defaults affect your credit at the exact point and remain on your credit report for up to 7 years. Your credit score can be tremendously affected by just one missed EMI.
4. Co-signing comes with emotional costs, and in some cases, legal costs along with the financial risks to you.

Precautions before co-signing

Before you agree to co-sign, ask yourself:

• Am I financially able to repay the loan if I have to pay it back?
• Am I confident in the borrower's ability to handle their finances?
• Am I putting my credit on the line for this person?

How to mitigate the risks?

• Set reminders to monitor the payments.
• Review the monthly statements from the loan account, or request shared access.
• With the borrower, create an agreement to pay back the loan together.
• Use credit monitoring tools to stay up to date on any adverse activity.

Implications of joint credit responsibility

Co-signed loans are considered when lenders look at your debt obligations. Therefore, the addition of a co-signed loan may reduce your ability to deal in borrowings for future credit cards or loans, meaning your debt-to-income ratio is increasing. A greater debt-to-income ratio may present you as a higher credit risk to lenders, and in turn, may affect your interest rates.

In conclusion, good communication and a joint effort to operate from a foundation of financial responsibility is a prerequisite to your willingness to help. Remember, your credit score is your financial reputation. Take steps to protect it.

Disclaimer: Mint has a tie-up with fin-techs for providing credit, you will need to share your information if you apply. These tie-ups do not influence our editorial content. This article only intends to educate and spread awareness about credit needs like loans, credit cards and credit score. Mint does not promote or encourage taking credit as it comes with a set of risks such as high interest rates, hidden charges, etc. We advise investors to discuss with certified experts before taking any credit.