Co-signing an auto loan is one of the most misunderstood topics in the car-buying process. If you have excellent credit, there’s a good chance that a friend or family member has asked you to co-sign a car loan at some point. If you’re saddled with bad credit, you may have been the one asking for a co-signer.
Before you ever think of co-signing a loan, there are several things you need to know. While it can be an excellent idea for borrowers with bad credit or no credit at all, it's fraught with peril if you’re the one with good credit being asked to take on the risk of co-signing.
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In this guide we’ll cover the following topics:
- What Is Co-Signing?
- Benefits of Co-Signing
- Dangers of Co-Signing
- Avoiding Co-Signed Auto Loans
- Finding a Loan to Co-Sign
- How Do You Co-Sign a Car Loan?
- How to Get Out of a Co-Signed Car Loan
- What Happens if You Default?
Having someone co-sign a loan is a way for someone who has poor credit or who doesn’t have enough credit history to get a loan by piggy-backing on the good credit of a creditworthy co-signer who is willing to put their name on the loan documents. Both parties are legally responsible for repaying the entire loan balance, regardless of who is supposed to be making the monthly payments or owns the vehicle.
Unlike co-borrowing or co-buying, co-signing a loan does not give the second party any ownership rights in the vehicle. They take on the risk of the loan with none of the benefits of being able to use the car. If payments are made on time, both the primary borrower and any co-signers can see their credit scores rise. On the other hand, if one person does not pay, both party’s credit scores are at risk.
Some think that co-signing a loan is merely acting as a character reference for the primary borrower. The truth is far riskier. If the primary borrower does not pay, the lender is legally entitled to come after a co-signer for payment of the loan, late fees, and repossession costs.
If it sounds like co-signing on an auto loan is a bad idea, that’s because it frequently is. If you choose to do so, you need to be careful how you do it and closely monitor the loan to ensure that timely payments are being made. Requests to co-sign can come with heaps of family drama, pressure, and hard feelings if declined. Friendships can suffer if someone decides not to co-sign on a loan, or the primary borrower stops paying.
For borrowers with horrible credit scores or no credit history at all, a co-signer can be a lifeline that allows them to get a car. A co-signer with excellent credit can help you get a car loan with a decent interest rate, rather than one with an extremely high interest rate and restrictive terms. Having someone share the risk can also allow you to buy a car that’s more expensive than you would otherwise be able to afford. If you have no credit history at all, it can be challenging to get a loan that you can pay off to prove you can responsibly handle credit and build your own score.
If the borrower pays the loan payments on time each month, both the principal borrower and co-signer can see their credit scores rise. That's far more meaningful for the borrower with bad credit, as it might allow them to refinance the loan with no co-signer or take on new debt with no co-signer.
Another situation where haging a co-signer is advantageous is for recent college graduates with lots of student loan debt. Their debt-to-income ratio may make them ineligible for automaker-subsidized below-market-rate or zero percent financing deals. A co-signing parent can help them qualify for the special car incentives, which can save the recent graduate thousands of dollars in interest over the life of the loan – while assisting them in building a solid FICO score and other credit history benchmarks.
When considering whether to co-sign a loan, you need to look at the totality of the person’s financial difficulties. If their issue was a medical crisis, for example, that made them miss some payments, but now they’re working diligently to get back on their feet, that’s a different situation than someone who racked up tens of thousands of dollars in credit card debt on lifestyle spending they could not afford. One was an unavoidable incident, while the other shows a history of bad decision making.
Beyond the emotional toll that co-signing can have on family relationships or friendships, there are many other reasons to pause and consider the pitfalls of co-signing an auto loan. While the advantages of co-signing are tilted toward the main borrower, the dangers of doing so are aimed squarely at the co-signer.
Risk of Default
If the primary borrower does not make their payments on time, the co-signer is legally obligated by the loan's terms to make the payments. Failure to do so can result in loan default and vehicle repossession. While the co-signer might not care if the vehicle is repossessed, because they have no ownership interest in the car, the effects of a default and repossession on their credit score can be profound. The great credit score they took decades to build could evaporate in a heartbeat, making it difficult to borrow money again. Even if they can qualify for another loan, they’ll likely face a significantly higher interest rate and find themselves ineligible for special car deals.
Debt collectors are legally entitled to use the same tactics against the co-signer as the primary borrower, and they’re likely to do so, as the co-signer probably has deeper pockets than the main borrower. The amount they are liable to pay is not divided between the applicants – each signer is responsible for the entire loan amount.
The tools in the debt collector's toolbox include the ability to sue for a legal judgment and demand wage garnishment until the loan is brought up to date. Even if the car is repossessed, everyone whose name is on the loan documents is liable for paying the difference between the car’s value and the loan balance, plus the costs of repossessing the vehicle. Collectors will frequently go after the party they feel is most likely able to pay, and that's probably the person with the highest credit score, income, or asset base. Different states have different rules about what assets can be seized to satisfy judgments.
Because auto insurance companies consider credit reports when setting premiums, the co-signer could see their car insurance premiums increase if the loan they co-signed fails.
You May Not Be Able to Open New Lines of Credit
One of the key metrics lenders consider when evaluating a loan application is the borrower’s debt-to-income ratio. No matter how good a person's credit is and whether they make their car payments on time, if their debt-to-income ratio is too high, they either won't get a new loan, or they will have to pay a higher interest rate. Because co-signed loan debt counts against the co-signer's debt-to-income percentage, being a co-signer can limit their ability to refinance their home loan, get another car loan, apply for credit cards, or qualify for a mortgage.
In other words, even if everything goes right, co-signing for someone else’s auto loan can prevent you from accessing credit for your own use.
Sometimes it is difficult to say no to a relative or close friend who needs your help so they can get a car. Often their backs are up against a wall, with the need to get to work, but a credit rating that doesn’t leave them with many options.
As hard as it may be, you have to consider your financial situation first before agreeing to co-sign a loan for someone. Can your budget take on the other party’s monthly loan payments if they fail to pay without undue stress? If you had a family emergency, would the additional debt limit your ability to pay for unexpected expenses? Are you looking to buy a new house during the term of the loan you would be co-signing? Is your credit history strong enough that it could take a ding if the primary borrower was late on a payment?
If someone is asking you to be a co-signer on a car loan for a fancy new car, and won’t consider a pre-owned vehicle or a more affordable new car, you should probably consider it a red flag and opt not to help them out with their financing.
Protecting Yourself if You Co-Sign
If you do decide to co-sign a loan for a friend or family member, there are a few things you must do to protect your credit record and avoid having to pay for the loan yourself. First, the person asking you to co-sign a loan should give you a copy of their credit report so you can see why they have bad credit. If they won’t, you have a good reason to decline their request. Many people are uncomfortable talking about their personal finances, but this is one instance where it’s essential.
Second, talk to the lender and make sure that you have online access so you can see that the debt is being paid with on-time payments and no late payments. If possible, set up alerts so you are notified the instant the obligation is not being met.
Though its legal force may be questionable, you can also create an agreement where the primary borrower promises to sell the car and use the proceeds to pay off the loan balance if they fall behind on their payments. If nothing else, putting such an agreement in place lets the buyer know that you’re serious about the repayment of the loan.
Alternatives to Co-Signing
When you simply cannot or don't want to co-sign a loan, there are some alternatives you might propose.
You might suggest making a peer-to-peer loan to your friend or family member for a down payment that reduces the amount they need to borrow or lowers the car loan’s loan-to-value (LTV) ratio to a point where they don’t need a co-signer. Losing the $1,000 you lend to someone on a personal loan could be a better alternative than having them default on a $5,000 loan that has your name on it.
You can help them in their car shopping, with the goal of lowering the price of the car they are buying to a level that doesn’t require a co-signer. There might be some tough love needed along the way, and their willingness to accept the help may be a good barometer of how they would respond if they had problems making their loan payments. If they’re unwilling to listen to you while you’re trying to help, imagine what they might be like when they’re in financial trouble.
The worst way to get into a co-signed loan is to go car shopping at dealerships with your friend or family member, only thinking about the financing once you’re starting to negotiate the car purchase. Smart car buyers know always to get a preapproved financing deal before they get anywhere near a car dealer.
Auto loans are available from a variety of sources, including large national banks, community banks, credit unions, and finance companies. Since getting financing is likely to be challenging for you and your co-applicant, it’s a good idea to focus your shopping on smaller institutions, such as community banks and credit unions, where you’re more likely to get personal attention, rather than a one-size-fits-all loan offer. Some lenders have special programs for buyers with bad credit or first-time buyers with limited credit histories.
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Co-signing a loan isn’t as simple as signing your name onto someone else’s loan application. Because both the primary borrower and any co-signers are responsible for the entire amount of the loan, they all have to complete loan applications. The loan terms offered by the lender will typically reflect the credit score and debt-to-income situation of the applicant with the strongest credit history.
A loan application will ask about your income, employment, assets, and debts. Everything from credit card debt to student loans and rent needs to be listed. Resist the urge to inflate any numbers or lie on the application, as it could lead to a declined loan or a demand for immediate payment if a lender later finds out about the false information.
The lender will pull credit reports on all loan applicants to assess the creditworthiness of each individual. When they do so, it will lower the credit scores of all of the applicants, including the co-signer, by a few points. It’s important to remember that you’ll need a creditworthy co-signer. The loan can still be declined if you have two or twenty co-signers, and they all have bad credit.
If the primary borrower ends up being unable to make payments, you'll probably want to get your name off the loan. Unfortunately, in most cases, you can't. You’re on the hook for the entire loan balance if they fail to make on-time payments. Co-signer rights vary by state, but generally, you should treat co-signing a loan as agreeing to a binding contract.
Some loans include a co-signer release clause that gets your name off the loan after a certain number of on-time payments are made. Such provisions on auto loans are rare, however. The only ways to really get your name off the loan is just to pay off the loan balance, or have the primary borrower refinance the loan after their payment history is strong enough they no longer need your name on the loan.
If the borrower has been successfully making payments for an extended period, and they can prove they are a better credit risk than they once were, a lender may be willing to release a co-signer from the debt. There’s nothing that says they have to, though.
When you have indications that the loan is about to go south, it’s a good idea for co-signers to talk to the primary borrower and encourage them to sell the car. Even if they're underwater on the loan (they owe more than the car is worth), selling the vehicle and using the proceeds to pay off as much of the loan as possible is an excellent way to get out of the loan with minimal damage to your own finances. Of course, you’ll have to ask nicely, as co-signers (unlike co-buyers or co-borrowers) have absolutely no ownership interest in the vehicle, even if they have been making the car payments.
It’s important to note that we said if “you” default. In the eyes of the lender, if one person stops making timely payments, everyone whose name is on the loan is considered to have stopped making payments.
Unless you’re monitoring that status of the loan, which you should be, the first indication of a problem will likely be a notice or phone call from someone at the lender. If there’s no response from the primary borrower or co-signer, the loan can drift into default status. The vehicle can face repossession, and everyone whose name is on the loan will be getting calls from collection agencies. When a borrower defaults, collections agencies will typically go after the co-signer with the deepest pockets, as they have the best chance of getting money from them.
Even if the primary borrower files for bankruptcy, the creditor can go after co-signers on the loan.
At this point, your good credit will have taken a substantial hit, and your friend or family member who you tried to help will have gone from merely having bad credit to having horrible credit. They likely will end up losing their car in the process. Even if the vehicle is repossessed, everyone on the loan is still liable for the costs of collection, repossession, and any difference between the value of the car and the loan balance.
After reading this article, you can probably tell that we think co-signing a loan isn't a very good idea. In most, but not all, cases that's true. If you do decide to co-sign an auto loan, you need to be careful how you do it and remain vigilant until every penny of the financing is repaid. It takes a long time to build a good credit score, but a single mistake to lose it.
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