Understanding the Impact of Cosigning a Loan on Your Credit Score

With roughly 178 million Americans having at least one credit card and an average credit score of 711 nationwide, understanding how cosigning a loan affects your credit is essential, regardless of income level. Many individuals with lower incomes may consider cosigning agreements, assisting others in their path to better financial standing. Recognizing the implications of such a decision on one’s credit score is critical to maintaining healthy credit management.

What Does It Mean To Cosign a Loan?

Before diving into the impact on your credit score, it’s crucial to understand what cosigning a loan entails. When a friend or family member has a limited or poor credit history, they might have trouble getting approved for loans. By cosigning a loan, you’re voluntarily agreeing to take the financial responsibility if the main borrower cannot pay the loan back. This is a significant commitment that should not be taken lightly as it can have long-term effects on your financial health.

How Cosigning a Loan Impacts Your Credit Score?

Cosigning a loan does not only mean you’re vouching for the person economically; it also means that the loan is now part of your credit history. The five key factors that are instrumental in calculating your credit score can be affected in the following ways:

1. Payment History:

   You may not be making the payments directly, but if the primary borrower defaults or misses a payment, this could negatively affect your credit score since it reflects on your report too.

2. Credit Utilization:

   Cosigning a loan adds to your existing debt. Therefore, if you were to apply for a loan or credit, lenders may see that your credit utilization is high, which could lower your credit score.

3. Credit History:

   This loan becomes part of your credit history. If payments are made on time and the loan is handled properly, it could improve your credit score. On the flip side, missed payments and debt can harm your score.

4. New Credit Inquiries:

   When you apply for a loan, a hard inquiry is made on your credit report. This temporarily reduces your credit score. So, cosigning a loan adds another inquiry to your credit report.

5. Credit Mix:

   It refers to the types of accounts in your credit report. If the loan you cosigned is a new type of credit for you (for example, auto or student loan), it could potentially improve your credit mix.

Preserving Your Credit Score as a Cosigner

If you decide to cosign a loan, there are some steps that you can take to protect your credit score:

1. Communication:

   Maintain open lines of communication with the primary borrower. They should inform you if they are unable to make a payment in time.

2. Check Your Credit Report Regularly:

   Since a cosigned loan will affect your credit, it’s important to keep an eye on your report. This can help you act promptly if your credit score starts to drop.

3. Arrange for Electronic Notifications:

   Many lenders offer notifications about upcoming payments or missed payments. By opting into these features, you can avoid unpleasant surprises.

4. Prepare for the Worst-Case Scenario:

   Have a strategy in place if the primary borrower defaults on the loan.

Thinking Twice Before Cosigning

Cosigning a loan can be a generous act to help someone in need. However, it’s crucial to weigh the potential costs to your credit score. Careful consideration should be given before taking this step. Remember, protecting your credit is an essential aspect of financial health.