How to Co-Sign for a Loan Without Hurting Yourself

If you are considering co-signing for a loan to help out a close friend or family member, the best advice is to walk away. Don't do it. It could cause real harm to your credit score and to your qualification numbers when you need a mortgage yourself. But, if you must be a co-signor, then make sure you follow some simple rules to ensure it won't hurt you in the long run.

First, let's take a look at why co-signing on a loan can hurt you, even though the financing is not really your loan. There are really two main ways that people shoot themselves in the foot when they try to do the nice thing by agreeing to co-sign for a friend's or family member's loan. The first way that you can get hurt is if the person whom you are helping fails to make the payments on time. Don't think that could ever happen? Then ask yourself this: why does this person need a co-signor in the first place?

The second way that co-signing for a loan could harm you is when the monthly payments of that loan count as your monthly debt and ruin your debt-to-income ratios. For example, let's say that you are looking for a mortgage. In this example, let's say you want to build your own home as an owner builder, so naturally you will need a construction loan. The bank is going to compare your monthly debts to your gross monthly income. If your monthly debts are too high, then you will not qualify for the loan.

Unfortunately, you may have a harder time qualifying if you didn't have to count that loan for which you co-signed. And, even if you do qualify, you will often face higher interest rates or stricter loan terms based on the fact that you now have a higher debt-to-income ratio.

So, whether you are looking for an owner builder construction loan or a simple refinanced mortgage, there are some things you should do to ensure that co-signing another person's loan won't hurt you. The first rule of thumb is to always say no to co-signing in the first place. But, if you must do it, then make sure you follow these three steps.

1. Ensure that you, the co-signor, will receive notification of payment each month. And, more importantly, ensure you will receive notification of any missed payment. If you set up this notification properly, you can hear the warning bells of a missed payment before the lender documents the account as being 30 days late. Once the account is late beyond 30 days, then the late payment will be reported to the credit bureaus. Your credit score will also reflect that you have a late payment, and your score will drop dramatically.

However, ensuring there are no late payments isn't just protecting your credit score. It's also protecting your debt-to-income ratio in the long run. Let's go back to our owner builder construction loan example. Let's pretend that you co-signed for a family member's loan over a year ago. Now, you are applying for your owner builder loan. If you can document that the family member has paid the loan out of his own pocket on time each month for over a year, then you won't have to count the monthly debt against your debt-to-income ratio.

But, if there were ever any late payments on that account, then the owner builder lender (just like any bank for any type of mortgage) is going to count that monthly payment as one of your monthly debts. Likewise, you have to be able to document that the person for whom you co-signed is the one who was making the payments each month for at least one full year. This brings us to our second step.

2. Ensure that the person for whom you co-signed is going to pay with a check or a direct deposit from his own personal account. This way, as long as the payments have been made on time for a full year, you can document that they came from the co-signee. It's especially helpful if the person pays with a check or a direct deposit from his account, because you can show either twelve cancelled checks to document the payments or twelve bank statements that have the direct deposit listed on them.

But, remember, almost all lenders, whether you want an owner builder loan or a simple mortgage to buy a home, are going to require at least a twelve month history before they will consider waiving the monthly payment from your debt-to-income ratio. This brings us to our third step.

3. If you agree to co-sign for a loan, make sure that you can afford to count this extra payment in your debt-to-income ratio, even if you don't plan on making the payment yourself. In other words, do the math. Pretend you are the bank in the owner builder loan example. Calculate your debt-to-income ratio, and make sure you include the monthly payment from the co-signed loan. This way, if you need a new mortgage before you can document the twelve month history of the co-signed loan, then at least you won't have to worry about your debt-to-income ratio. You will still run the risk of a decreased credit score if there is ever a 30 day late payment, but that's why you are wisely following steps one and two above.