If you're asked to cosign a loan, you need to think about this issue.
Cosigning a loan means vouching for the primary borrower and betting your credit on their ability to pay.
When you decide whether to cosign, your main focus should be on the likelihood of default. After all, if the person you're cosigning for doesn't pay the bills, you'll be on the hook to cover them -- and your credit could be damaged in the process.
But there's another reason why you may wish you hadn't said yes to cosigning, even if the primary borrower pays back the loan on time and in full. You could end up affecting your own ability to borrow in the future, even if everything goes well.
Don't forget about this possible consequence of cosigning
When you cosign a loan, the debt shows up on your credit report since you're one of the people who is legally responsible for paying it.
The problem is that when you need to take out a loan, such as a mortgage, car loan, or personal loan, lenders are going to consider your debt-to-income ratio (DTI) when they decide whether or not to allow you to borrow. And they won't distinguish between your personal debts and those you cosigned for.
Your DTI is the amount of your total monthly debt payments relative to the amount of income you have. If you've cosigned for a loan, its monthly payment is included in your DTI. And that could potentially put you over the limit for borrowing at all or for getting the best rate.
Say, for example, you're trying to get a mortgage loan with a lender that wants your total debt payments -- including your mortgage -- to be below 43% of your monthly income. Say you have $4,000 in monthly income, a $300 monthly car loan, and no other debt, and you want to borrow $1,200 a month to buy a home. In that case, your DTI would be below 43%. ($1,500 in debt divided by $4,000 in monthly income equals 37.5%.)
But if you'd cosigned for a friend's personal loan that has its own $300 monthly payment, that would push you to a total monthly debt of $1,800. Since your debt payments would now eat up around 45% of your monthly income, you likely wouldn't get your home loan. ($1,800 in debt divided by $4,000 in monthly income equals 45%.)
Unfortunately, the monthly payment on your cosigned loan will continue to affect your ability to borrow until the loan is paid off in full -- even if the primary borrower is steadily making payments on time and there's no reason to believe you'll get stuck covering the loan costs. The larger the monthly payment on the loan you cosigned for and the longer the repayment timeline, the more likely it is that your own ability to borrow will be impaired.
It's important to consider this consequence of cosigning before you agree to do it, even if you have no reason to believe the person you're helping get a loan won't repay it on time. If you plan to take on debt of your own in the near future, you may have to say no so you don't close off your own borrowing options in your attempt to aid a friend.
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