As a parent, budgeting for college is no easy feat. Fidelity Investments reports that parents who plan on footing the bill are on track to fall 71 percent short of their funding goal by the time their children reach college. It's more than likely that beyond grants and scholarships, you may have to look into student loan options.
After federal loans are maxed out, most private lenders will require a cosigner for your college-bound student's loans. But what impact will cosigning have on your finances, and your credit score? If your child handles the loan responsibly, it could very well work out in your favor – making steady, on-time payments will bode well for both your credit scores. In other words, it could translate to a hands-off way to maintain a robust score, or even boost a score that needs a little work.
Borrowers are also more likely to land a lower interest rate if you opt in as a cosigner. Another perk? Since most high school grads don't have much of a credit history, cosigning for them helps get them established so they can begin building credit of their own.
If you'll be serving as a cosigner, it's important to understand all the details before signing on the dotted line. Here's exactly how cosigning a student loan can affect your credit.
How Cosigning a Student Loan is Linked to Your Credit
When you cosign a student loan, you're assuming financial responsibility should the borrower fail to make good on their payments. You aren't simply vouching for the borrower; you're promising to cover the payments if they don't. That means, from day one, that the loan will show up on your credit report.
"Parents are the ones who tend to put themselves in financial harm for the benefit of their children, but they really need to take stock of their current financial situation before going through with it," Davon Barrett, an analyst at Francis Financial, tells CommonBond. "If the student negatively handles this loan, that's a negative for your credit score, too."
Making late payments falls under this umbrella. According to a 2016 study put out by the Financial Industry Regulatory Authority, 37 percent of borrowers who had payments due had fallen behind at least once in the previous year. A quarter had been late multiple times.
FICO, the leading credit reporting agency, considers a number of factors when determining your score, but payment history carries the most weight. Amounts owed comes in right behind it. But again, the important thing to remember is that the knife cuts both ways – a borrower who makes regular, timely payments will actually improve your score without you having to do anything.
How Cosigning Affects Your Ability to Take Out Other Loans
When you apply for any type of new financing, whether it be an auto loan, a mortgage, or anything in between, a lender may look at something called your debt-to-income ratio (DTI) to evaluate your creditworthiness. It's basically a snapshot of how your debts measure up against your income (CommonBond is unique in that it looks at many different variables to determine creditworthiness). For example, let's say you earn $6,000 a month and your debts look like this:
- A $15,000 car loan that requires a $250 monthly payment
- A $120,000 mortgage that requires a $1,200 monthly payment
- A $3,000 credit card balance that requires a $100 monthly payment
- A $20,000 student loan which you cosigned; the borrower pays $250 a month
Since you cosigned for that loan, the lender treats that $250 monthly payment as your own. To determine your DTI, you add up all your monthly payments, then divide it by your monthly income. In this case, it comes in at 30 percent.
If you won't be applying for another loan in the near future, then you're all set. However, you may want to calculate how much this student loan may affect your DTI. "Take stock of your current goals and any large credit purchases you're going to make in the near future," says Barrett.
At the end of the day, your credit score is the most important factor that comes into play when applying for any new financing. If cosigning will give your score a boost over the long haul, it's well worth it.
How to Protect (or Boost) Your Credit When Cosigning a Loan
The most important question to ask yourself before cosigning, according to Lazetta Rainey Braxton, CEO and founder of Financial Fountains, is if you're willing to assume the loan payments if the borrower cannot. If your monthly budget can't absorb that new payment, you may want to think twice. You also want to make sure the borrower will make payments on time, to maintain your credit score.
That said, the borrower could still dial up your credit score by making consistent, on-time payments. The takeaway? Be sure to keep the lines of communication between yourself and the borrower open. Set yourself up for success by going into it with clear expectations so that they're comfortable with the terms and monthly repayment amount from the onset. Well-defined boundaries are your best defense. From there, you can sit back and enjoy the benefits of cosigning.
For more information on how to take out the loans you need for school, click here.