The Do’s and Don’ts of Co-Signing on a Loan
As your children approach adulthood, establishing good credit history is essential to a strong financial future. Quite often, a young adult’s first experience with credit is by way of an auto loan when purchasing their first car. Due to lack of credit history, banks usually require a parent (or an individual with established credit history) to co-sign on the loan and ensure that there will be sufficient income to cover the payments. While this is an important milestone in your child’s life and a great way to teach them fiscal responsibility, it’s also important to know how co-signing on loans can affect your own credit.
When you co-sign a loan with someone, not only are both of you legally responsible to make the payments, but the loan will also influence your qualifying debt-to-income ratio. Despite any arrangements you make with your child, banks will take this debt into consideration when they evaluate your ability to make payments on future loans.
If you can show a 12-month history of the child making the payments on their own, your co-signed loan can be excluded from your debt ratio. Here are some DO’s and DON’Ts to follow:
- DO make sure that payments come directly from the child’s bank account. The best practice is to set up automatic payments or pay by check to easily prove their payment history.
- DON’T make cash payments. Cash payments are more difficult to prove.
- DON’T collect the funds from your child and make the payments on their behalf. If the history shows that the payments are coming from your account, the loan will not be eligible for exclusion from your debt ratio.
- DO be careful when co-signing on more than one loan. If you have multiple children and you co-sign on their vehicle loans or student loans, each loan will count against your own debt-to-income ratio until you’ve established the 12-month history of payments made by the children.
Understandably, you want to help your children get a good start in adulthood. Whether it’s an automobile, a quality education or any other need that may arise, being their co-signer will help them establish credit history and teach them financial responsibility. By planning ahead, you can make sure that your finances won’t be adversely affected in the process.