When You Should (and Shouldn’t) Take Out a Loan
Taking out a loan is not an easy decision because it can have serious consequences on your credit and finances. While helping a friend or family member may seem like a kind gesture, it is important to understand the risks and considerations involved. Let’s look at what it means to get a loan, when it might be appropriate, and when it’s best to avoid it.
What does it mean to co-sign a loan?
When you co-sign a loan, you are essentially lending your good credit to someone else. You become equally responsible for repaying the debt even if you do not receive any of the borrowed funds. If the primary borrower fails to make payments, the lender may come to you for the money.
Of course, taking out a loan can really help a loved one who doesn’t have a good credit history. The main advantage is that it allows a person with a bad or limited credit history to obtain a loan that they could not qualify for on their own. Co-signing can help a young person gain access to higher education that they might not otherwise be able to afford, especially for things like student loans. If payments are made on time, this can help the primary borrower build or improve their credit score over time. And even if the cosigner has decent credit, the borrower may receive better loan terms, including lower interest rates and potentially higher loan amounts.
When might you consider co-signing?
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You can help a trusted family member : Co-signing means you can help a close family member by having a clear plan for how to afford whatever you sign up for. If your child or sibling needs help getting a loan and has a clear ability to pay it off, co-signing may be smart.
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It’s a short-term loan : You can also take on less risk by signing a short-term loan rather than a multi-year commitment. If someone needs a guarantor for something that will be paid off in less than a year, for example, it may make more sense.
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You have deep pockets : If you actually have a sufficient financial cushion and can accept payments when needed, the risk may be more manageable.
When to avoid co-signing
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This may affect your ability to qualify for credit : Lenders look at your debt-to-income ratio when they consider opening you up for new credit accounts. If you already have a large amount of debt, adding a cosigned loan may also affect your ability to qualify for additional credit.
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This will put a strain on your finances : if the person you’re signing the contract on behalf of fails to make payments and you’re suddenly on the hook, will you be able to afford it? If this will put a strain on your finances, do not sign up. You must put your finances first; and if you’re about to apply for a mortgage or other significant loan, co-signing may complicate your own borrowing process.
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You don’t trust the person you sign the contract for . First of all, you should never sign if you have any uncertainty in your relationship with the borrower. If you are not completely confident in the borrower’s ability or desire to repay the debt, it is better to refuse.
Alternatives to Co-Signing
Issuing a loan is not the only way to help a financially strapped loved one:
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Money as a gift . Instead of signing a contract, it’s better to just give someone money. This limits your liability and potential credit exposure.
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Secured credit card . For those getting credit, a secured credit card (on which the user makes a deposit) may be a lower-risk option.
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Act as a guarantor for a loan . Some lenders will allow you to be a co-signer, which may have less of an impact on your loan than co-signing.
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Help with a larger down payment . Making a down payment can reduce the loan amount, potentially making it easier for the borrower to qualify for the loan on their own.
Bottom line
Loan cosignation is a serious commitment that should not be taken lightly. While this may be a way to help someone you care about, it is important to carefully consider your financial situation and the potential risks involved. In many cases, exploring alternatives or simply saying no may be the smartest way to protect your financial health.