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What to Know Before Asking Someone to Cosign on Your Small Business Loan

by Mike Abelson   August 23, 2017
Learn about the risks a cosigner takes when helping you find funding.
Financial Preparation

Here are the dangers of cosigning a small business loan.

We all want to make it on our own, but sometimes you need help. That’s doubly true when you’re applying for a small business loan that requires a co-signer. It may be necessary, but before you search for someone to sign that dotted line, read on for the pros and cons of being a business funding co-signer.

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What is a Co-Signed Small Business Loan?

A co-signed small business loan is any form of business funding that is guaranteed by a co-signer. A co-signer, or “guarantor,” agrees to pay if you default on the loan. Typically, a co-signer has good to excellent credit and substantial assets.

Besides helping you get approved for funding that you may not have otherwise qualified for, the benefits of using a cosigner may include getting a lower interest rate, being offered a larger sum of money, and avoiding the need to offer up collateral.

What are the Risks for You?

Having a co-signer on your loan doesn’t add much risk to your business, but it could seriously jeopardize your relationship with the co-signer, which may lead to added stress for you.

There is another way to look at needing a co-signer: If you weren’t able to qualify for the loan on your own, maybe that says something about your ability to repay the loan.

It should also be noted that you may need to sign a personal guarantee. A personal guarantee is an agreement you make with the lender where if you cannot pay back the loan with your business’s profits, then you will personally pay back the loan. If that falls through, then it’ll be up to your co-signer to repay the loan.

Warning: If you sign a personal guarantee, then even if you own a limited liability company (LLC) or an S corporation, your personal assets may still be jeopardy should you default on the loan. The same goes for your co-signer. For these reasons (and many more), you should have a professional look over your loan agreement before you sign anything.

What are Their Risks?

Your co-signer should think long and hard about whether or not they want to do this for you. Here are some of the not-so-great aspects of their side of the situation:

  • If you don’t pay back the loan, they have to pay it back. That’s how this works. The loan will be as risky for them as it is for you.
  • If they have to pay back the loan, they could suffer bankruptcy, financial ruin, loss of property and possessions, etc.
  • They could have trouble qualifying for a loan of their own. A creditor will see the co-signed loan as a debt against your co-signer. It doesn’t matter that you’re the one paying back the loan. The creditor has to take that debt into account because there’s always a chance you’ll default on the loan.
  • If you miss a payment, then it could damage your co-signers credit rating. Your co-signer might not even be notified about your missed payments until a debt collector gets involved.
  • Your cosigner is equally responsible for paying off the debt and will be in just as much trouble if the debt doesn’t get paid. That means having to pay late fees if there are any, and even having wages garnished.
  • If you miss a payment, the loan provider or its debt collection agency can immediately start going after the cosigner. This is more common than you might think.
  • The cosigner’s credit will take a hit during the life of the loan. If she tries to borrow money, the amount of debt on your loan will count against her, making approval more difficult. If you default on the loan, the cosigner’s credit will again suffer.
  • While a cosigner and a co-borrower aren’t always the same thing, in some cases a co-borrower will co-own whatever you use the money to purchase.
  • If the loan falls apart, your friendship probably will, too. Even if the loan goes off without a hitch, the stress added to the cosigner’s life may have damaged your relationship.

If you decide to seek out a co-signer, make sure they know about these risks, too. You don’t want them to say later on that you tricked them into anything.

How You Can Make It Better for the Cosigner

When looking at the risks involved in cosigning a loan, it becomes a wonder that anyone agrees to do it. If you’re having trouble getting someone to sign the dotted line, there are ways to make the offer more appealing.

First, you should use a contract that shows what the cosigner will be responsible for and what will happen if the cosigner takes over the loan. The arrangement will seem more reasonable if the cosigner gets your business in recompense for paying off the loan if that should happen.

The contract could state that if your cosigner takes you to court over the loan, you agree to be responsible for her legal fees.

You can also put in writing that you plan to take the cosigner off the loan later when you refinance the loan.

These assurances will go a long way to making your friend or family member feel more comfortable about the loan.

What’s the Benefit?

Let’s assume you’re applying for a traditional business loan with an interest rate. You want that interest to be as low as possible because a lower rate usually translates to a cheaper loan. There’s a chance your credit rating alone won’t qualify you for the lowest rate. But, if you have a co-signer with an incredible credit rating, then you might be eligible for a better rate, which could end up saving you money on the loan. In some cases, lenders might be willing to offer you a higher loan amount if you have a co-signer.

That’s assuming that you’ll even qualify for the loan without a co-signer. Some lenders want you to either offer up significant collateral or have a co-signer. Collateral might not be an option for you. (We recommend that you try to avoid putting your possessions up as collateral for a business loan. If your business goes south, you don’t want to lose your assets on top of it.)

Should I, or Shouldn’t I?

It’s up to you to decide, but whatever choice you go with, we advise you to do some serious planning. If for no other reason (and there are plenty of other good reasons), having a solid business plan will help instill confidence in your co-signer. If you can’t convince them that the loan is a good idea, then maybe it’s not.

Should my Spouse be my Co-Signer?

Your lender may require your spouse to co-sign on your loan, which will make any assets your spouse owns subject to seizure if you should default on the loan. If your lender doesn’t ask your spouse to sign anything, we wouldn’t suggest bringing it up.

A Couple of Caveats

When the “weighted average method” is used to evaluate your co-signer, the lender will take into account how much of the business the co-signer owns. If your co-signer owns a small percentage of your company, then even if their credit score is very high, it will not have much bearing on the final decision. Conversely, the “non-weighted average method” looks the average of you and your co-signer's credit scores, regardless of how much of the business they own.

Chances are your lender will use one of those two methods to determine how much weight to give your co-signers credit score when deciding to offer you a loan, how much the loan will be, and what your interest rate will be. If your lender employs the “weighted average method,” then we suggest not bothering with a co-signer, since their impact will likely be outweighed by the risks we discussed earlier.

What if You Can’t Find a Cosigner?

Cosigning a loan is a risky venture. It has ruined more than a few friendships, and it shouldn’t be a surprise that many people have no interest getting involved with it. If you can’t find a cosigner, you might have better luck suggesting that your friend or family member just lend you the money themselves.

If you can’t get the entire amount, try for enough to make a down payment on what you plan to purchase.

Final Thoughts

There are small business funding products out there that don’t require collateral or a co-signer. These products tend to have higher fees. If you’re looking for the cheapest loan possible, you may need to go with a co-signer. And remember, just because you need one this time around doesn’t mean that’ll be the case next time. If you pay off your debt right, then you might improve your credit enough to fly solo for next big loan.

We hope this advice helps you decide whether or not to get a co-signer on your small business loan.

Mike Abelson   Editorial Director
Digital Marketing
Mike is the Editorial Director at Lendza. He enjoys helping entrepreneurs and startups succeed through smart, innovative strategies. He’s partnered with CEOs and executives to grow businesses from the ground up. Before his work at Lendza, Mike was a stock market analyst. When he’s not traveling for work, he enjoys reading adventure and science fiction novels.