Any loan you cosign on could become a thorn in your side.
While the consensus from financial experts is that you shouldn't cosign on a loan, people still wrestle with this decision. They consider cosigning other people's personal loans, auto loans, or, in extreme cases, even mortgages.
If you're in this situation, you may already know the obvious risks. You're responsible for the loan you cosign, and any missed payments or other repayment issues can affect your credit score. But perhaps you're confident that the borrower will pay, so you figure there's nothing to worry about. Although this is dangerous logic to use, let's assume you're correct.
The problem is that even if the borrower makes all the payments on time and does everything right, being a cosigner on a loan could still come back to bite you. That's because that loan will be considered your debt, so it could prevent you from borrowing money in the future. Here's why.
Cosigning increases your debt-to-income ratio
When you cosign on a loan, it's tied to you. For all intents and purposes, it's as if you applied for the loan and borrowed that money. One reason that's important is because it increases your debt-to-income (DTI) ratio.
Your DTI ratio is your monthly debt payments divided by your gross income. For example, let's say you earn $5,000 per month. The payments on your credit cards, student loans, and other debt add up to $1,000 per month. You would have a DTI ratio of 0.20, which would more commonly be expressed as 20%.
Then, a friend of yours asks you to cosign on a personal loan with payments of $900 per month. Even if your friend is making every payment, it will still add $900 per month to your total monthly debt payments. That will push your DTI ratio up to 38%.
How a higher DTI ratio affects you financially
A higher DTI ratio may not initially seem like a big deal. If the borrower is paying, does it matter that your DTI ratio has increased?
To lenders, it does. Any time you apply for a loan, line of credit, mortgage or a credit card, the lender is going to review your DTI ratio to evaluate the risk of lending you money. If your DTI ratio is too high, the lender could deny your application.
Although there's no set cutoff point when it comes to DTI ratios, there are common guidelines used by mortgage lenders. You have a better chance of approval when applying for a mortgage if your DTI ratio, including your projected mortgage payment, is no greater than 36%.
Let's go back to the example above, where you cosign on a friend's loan and raise your DTI ratio from 20% to 38%. If you want to buy a house in the future, cosigning on that loan could be the difference between whether the mortgage lender approves or denies your application.
The same is true with any type of new credit account you want to open. It becomes more difficult to get approved as your DTI ratio increases.
Does cosigning on a loan ever make sense?
Cosigning on a loan is a high-risk, no-reward situation for you. The worst-case scenario is that the borrower doesn't pay. As you're responsible for the debt, you will suffer a credit score drop that could take years to fix. Even in the best-case scenario, you'll have a higher DTI ratio, and that could limit your own financial opportunities. The only person who stands to benefit is the person asking you to cosign.
The smart approach is to politely decline these requests. You can give advice on how to raise their credit or boost their loan approval odds, but you shouldn't put your financial stability in someone else's hands.