How Cosigning A Loan Impacts Your Debt-To-Income Ratio

While the consensus from financial experts is that you shouldnt cosign on a loan, people still wrestle with this decision. They consider cosigning other peoples personal loans, auto loans, or, in extreme cases, even mortgages.

If youre in this situation, you may already know the obvious risks. Youre responsible for the loan you cosign, and any missed payments or other repayment issues can affect your credit score. But perhaps youre confident that the borrower will pay, so you figure theres nothing to worry about. Although this is dangerous logic to use, lets assume youre 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. Thats because that loan will be considered your debt, so it could prevent you from borrowing money in the future. Heres why.

Cosigning a loan for a friend or family member is often portrayed as a kind and generous act. However, taking on the legal responsibility for someone else’s debt is not a decision that should be made lightly. One of the key things potential cosigners need to consider is how it can negatively impact their own finances, especially their debt-to-income (DTI) ratio.

What is Debt-To-Income Ratio?

Your DTI ratio compares the minimum monthly payments on all your existing debts to your gross monthly income. It is calculated by dividing your total monthly debt payments by your gross monthly income and is expressed as a percentage.

For example if your total monthly debt payments are $2,000 and your gross monthly income is $5000, your DTI ratio would be

$2,000 / $5,000 = 0.4 = 40%

DTI gives lenders a snapshot of your ability to manage the debts you currently have in relation to your income Most lenders prefer to see a DTI of 43% or less when considering applicants for new credit A high DTI ratio can negatively impact your ability to qualify for financing.

Why Cosigning Affects Your DTI

When you cosign a loan, you are legally obligating yourself to make the payments if the primary borrower defaults. Even though you may not be the one actually making the monthly payments, the cosigned debt still counts against you for DTI ratio purposes.

Here’s an example

Your monthly debt payments: $2,000
Your monthly gross income: $5,000
Existing DTI before cosigning: 40%

If you cosign on a $20,000 auto loan with a monthly payment of $500, your new DTI calculation would be:

Total Monthly Debt Payments: $2,000 + $500 = $2,500
Gross Monthly Income: $5,000

New DTI = $2,500/$5,000 = 50%

By cosigning, your DTI is pushed up into a range that could jeopardize your ability to get approved for financing in the future. Even if you aren’t the one actually making the payments, lenders will see you as higher risk.

Other Potential Impacts of Cosigning on Your Finances

Aside from DTI, cosigning a loan can impact you in other ways:

Credit score – If the primary borrower misses payments or defaults entirely, it damages your credit history too. Late payments get reported to the credit bureaus and can significantly drag down your credit score.
Future borrowing power – That higher DTI ratio and lower credit score thanks to a cosigned loan may prevent you from qualifying for a loan or credit card you need down the line.
Legal liability – As a cosigner, the lender can pursue you legally for the debt if the primary borrower stops paying. This can mean getting sued or having your wages garnished.
Relationship strain – If the borrower fails to make payments as agreed, it can irreparably damage your relationship. You may come to resent the financial and credit impacts on your own life.

Tips to Mitigate Risks of Cosigning

If you decide to cosign a loan after carefully considering the impacts, there are some things you can do to reduce the risks:

Ask the primary borrower to sign a contract agreeing to make payments on time and keep you informed of any financial issues.
Get added as an authorized user on the loan account so you can monitor the payment activity online.
Set up alerts on your credit reports to notify you of any reporting related to the cosigned loan.
Have the primary borrower make an extra monthly payment that goes directly towards principal to pay off the loan faster.
Contribute to a savings account monthly to build a cushion in case you need to step in and make payments yourself.
Explore options to remove yourself from the loan after 1-2 years of on-time payments from the primary borrower.

Alternatives to Cosigning

Rather than put your own finances at risk by cosigning, here are some other options to consider assisting someone:

Gift funds for a down payment to help the borrower qualify on their own.
Add as authorized user on one of your credit cards to help build their credit.
Help improve their credit before they apply by reviewing credit reports and disputing errors.
Secured loan using collateral like a CD from you instead of cosigning.
Lend money directly for the purchase using a notarized promissory note.
Co-apply for joint credit by being a joint account holder.

For expensive purchases like auto loans or mortgages, cosigning should not be taken lightly. Be sure to fully understand the risks, quantify the impact to your own finances, and explore alternative ways to help that don’t put your credit and DTI ratio in jeopardy before making a commitment.

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Any loan you cosign on could become a thorn in your side.

Cosigning increases your debt-to-income ratio

When you cosign on a loan, its tied to you. For all intents and purposes, its as if you applied for the loan and borrowed that money. One reason thats 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, lets say you earn $5,000 per month. The payments on your credit cards, 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 Your Credit Will Be Affected If You Cosign|What Happens When Cosigning

FAQ

Does Cosigning show up as debt?

How Does Cosigning a Loan Affect My Credit? After you cosign a loan, the debt is your responsibility. You aren’t just the back-up for someone else’s loan. The creditor can report the loan to the credit bureaus as your debt.

Does cosigning a loan affect buying a house?

Co-signing for someone else can impact your ability to get approved for a mortgage because it expands your financial obligation. The co-signed loan becomes part of your overall debt load, increasing your debt-to-income ratio (DTI).

What counts against your debt-to-income ratio?

Your debt-to-income ratio (DTI) is all your monthly debt payments divided by your gross monthly income. This number is one way lenders measure your ability to manage the monthly payments to repay the money you plan to borrow. Different loan products and lenders will have different DTI limits.