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If someone you know, like a close friend or relative, wants to apply for a car loan but fears rejection, they can ask for help. Maybe they have bad credit or a high debt-to-income ratio (DTI). Either way, they might ask you to co-sign on their loan to help them qualify.
Here’s what you need to understand before agreeing to co-sign an auto loan.
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Things to consider before co-signing a car loan
If you are going to become a co-signer, make sure you have a good credit rating, a solid history of paying on time, and/or a low DTI ratio. This will make the lender less concerned about loan approval and even help the borrower get a lower interest rate.
However, there are many other factors to consider when deciding if it’s a good idea to co-sign a loan or not. Here’s what you need to know:
What are your obligations
By becoming a co-signer, you agree to guarantee the other person’s debt. If the borrower defaults on the car loan or defaults, you will be required to repay the loan. However, keep in mind that when you agree to be responsible for someone else’s car loan, you are in no way getting title or ownership of the car.
You could become responsible for repaying the loan
As a co-signer, you are fully responsible for repaying the loan to the lender, not just vouching for the primary borrower. You are responsible for making the monthly payments if they stop paying. So make sure you have the ability to make those monthly payments now and in the future.
If the primary borrower defaults on the car loan, then the lender could sue both of you to claim the balance of the loan, depending on your state law, which could hurt your finances.
Co-signing will impact your credit
Before agreeing to co-sign, consider the impact this will have on your ability to access credit. Once you have co-signed a car loan, it will be listed on your credit report as part of the total amount of debt you have. This will increase your DTI, which could impact your ability to get a credit card, mortgage, or other loan.
Any missed payments on the car loan you co-sign can also make it difficult to get another loan in the future, as on-time payment history is a major factor in your credit profile.
How to co-sign a car loan
Co-signing a loan means that you and the primary borrower are responsible for the debt, so both of you will need to complete a loan application.
As with any car loan application, the lender will require proof of your work history – current and previous employers – as well as proof of your income. So, be prepared to provide recent pay stubs as well as documentation regarding any other assets and sources of income. If you are self-employed, you will need to bring two or three years of tax returns.
The lender will also pull your credit report to assess your creditworthiness. Remember that your credit score will suffer temporarily. So make sure you don’t plan to apply for another loan soon after.
How to withdraw from a co-signed car loan
If you decide to co-sign a car loan, you or the other borrower can decide as a last resort not to be jointly and severally liable for the repayment. Once you have obtained the agreement of the other party to remove your name from the loan, there are several ways to obtain the release of the co-signer:
- Refinancing: The most common way to remove yourself as a co-signer is to refinance the car loan. Through this process, the primary borrower takes out a new loan themselves, either with the same lender or with a new lender, to pay off the first car loan. This will end your legal obligation.
- Loan modification: This option usually comes with specific requirements that vary by lender. For example, in the event of the death of the co-signer, a loan amendment would be required to remove the name of the deceased from the loan. An amendment is also sometimes permitted if a couple is going through a divorce. One of the names is removed from the loan so that the other can retain ownership of the debt and the vehicle.
- Judicial settlement: You can file a civil lawsuit regarding who is responsible for repaying the loan or who owns the car. If the judge releases you from the agreement, a settlement order is issued to the lender, who initiates a loan modification. This course of action is most often included in divorce proceedings.
If you decide to co-sign a loan, protect yourself
The Federal Trade Commission (FTC) has recommendations for steps you can take to protect your financial well-being if you decide to co-sign a loan:
- Make sure the primary borrower has a budget. Whoever the primary borrower is, be it a friend or a family member, they should be prepared to show you how they intend to repay the loan. This will help both of you ensure that the monthly loan payments will be affordable.
- Know how much you might owe if the borrower defaults. Talk to the lender to find out how much you might owe if the primary borrower defaults and be prepared to pay that amount.
- Ask for regular loan updates from the lender. Ask the lender and primary borrower to send monthly statements for the loan so you can stay up to date. Also, ask them to commit in writing to notify you if a payment is missed or if the terms of the loan change. This way, you won’t be caught off guard and will have time to fix the problem.
- Keep copies of all loan documents. Make sure you get copies of all important loan documents, including the loan agreement, the Truth in Lending Act Disclosure Statement, and all collateral. You may need it in the event of a dispute between the lender and the borrower.
- Keep an eye on your credit report. It is very important to check your credit report at least once a month to catch any missed payments or errors. If you find an error, you can dispute it with the loan officer and credit reporting agencies.
- Check your state’s co-signing laws. Finally, check your state laws to see if there are any other co-signer rights.