Business Loan Cosigner: When Should You Use One?

When taking out a business loan, a cosigner is a person who is willing to give the lender a personal guarantee to repay the loan in full. This increases your chances of getting an approval because the business loan cosigner becomes 100% liable for the loan in the event that you fail to make payments. Cosigners are important when the business owner seeking the loan doesn’t have adequate credit or collateral to get the business loan financing on their own.

If you’re about to complete a business loan application, it’s good to know if you’ll need a cosigner before you start. This helps streamline the process and helps you get funding faster because the lender won’t come back with the cosigner requirement.

How Using a Business Loan Cosigner Works

Lenders look at a business’s ability to repay the loan. If the business is young, the lenders will want to see a personal guarantee from the owner. When the owner can’t personally guarantee the loan due to poor credit, lack of income, or a high debt-to-income (DTI) ratio, the bank will want a cosigner. This person steps in as the financial guarantor of the loan.

When everything goes right for the business, the cosigner is nothing more than a means to get the loan funded. However, if the business begins to experience financial difficulties, the bank will still demand repayment of the loan. If the business—or its owners—are unable to make the payments, the bank (or debt collector) will then send a notice to the cosigner to collect funds.

Keep in mind that, as the borrower, the cosigner does not always improve your credit rating and thus will not help you get a better interest rate on the loan. Often, the bank is underwriting the loan based on the primary borrower’s credit rating. This means that even if you plan on getting a cosigner, you might want to take the time to clean up your own credit as much as possible to qualify for the best loan terms.

How Will I Know That I Need a Loan Cosigner?

In most cases, you will be informed by the bank during the application process that a cosigner is required to proceed. For those who have a good idea that they will need a guarantor, you can save time by obtaining a cosigner prior to applying.

Some of the common reasons a cosigner might be required include:

• Increased creditworthiness: The cosigner can help someone who has poor credit or a history of delinquencies, liens, and bankruptcy on their credit report. The cosigner should be free and clear of any credit issues, thus giving confidence to the lender that repayments will happen.
• Qualify for larger financing amounts: When your DTI ratio is too small, the lender will want to see someone who has enough room in their monthly budget to pay the debt incurred by the loan.
• Prevent or reduce the need for collateral: Collateral is often used to guarantee a loan. When you have a cosigner with ample income resources to cover the loan terms, the need for collateral can be reduced.

Regardless of the reason why you need a cosigner, make sure that the guarantor understands that this loan will show up on his or her credit report as a debt they owe. This could affect them adversely when they seek to finance something like a car or home.

Loan Terms & Your Business Loan Cosigner

Loan terms refer to the total amount owed and the repayment schedule set by the bank. When adding a cosigner, both the borrower and the cosigner must approve and sign the terms and conditions of the loan. This means that the cosigner is acknowledging and approving every form that the borrower is signing.

The lender may require certain supporting documentation from the cosigner. When you applied, you likely supplied your own income resources as well as collateral. The same will be required of the cosigner.

Any cosigner must be willing to have their credit pulled and allow the lender to look into their income, debts, and assets. When someone cosigns the loan, they are accepting the fact that they are 100% liable for the asset—although they are trusting that your business will be successful.

How Lenders Evaluate a Business Loan Application With a Cosigner

Once a cosigner is brought into the loan application, then the loan provider will have to analyze the loan differently than they would if you were applying by yourself. There is no set way that a loan provider must do this, but it generally happens in one of three ways.

1. Weighted Average Method

The weighted average method primarily is focused on the credit scores of the business owners. Nonowners, even if they cosign the loan, get very little consideration. The loan provider will look at each owner’s credit score and weigh it according to their stake in the business―the larger your stake, the more important your credit score will be. The cosigner’s credit, in this case, has little or nothing to do with the approval decision. The cosigner is only helping the application if they can pledge collateral.

2. Nonweighted Average Method

The loan provider can also take the average of the cosigner’s credit score and the owner’s credit score, regardless of what the ownership amounts are. This gives the cosigner’s credit a larger role than in the weighted average model, but it’s still just a moderate impact on the total loan application. Combine this credit consideration with some collateral from the cosigner, and it becomes more significant, improving your chances of getting approved for the loan amount you want.

3. Best Credit Method

Under this scenario, the loan provider will only consider the best credit profile between the borrower and the cosigner. If you have bad credit, then finding a lender who uses the best credit method would be ideal because they’ll be relying entirely on your cosigner’s credit score. This means they are evaluating the cosigner as if they are the primary borrower.

The nonweighted average method is the most beneficial to you when you get a cosigner, and while it’s used more often for business loans than personal loans, you still shouldn’t bank on it. It’s a good idea to ask your loan provider how they analyze a loan application with a cosigner before you ask someone to cosign your loan. You probably don’t want to ask someone to cosign a loan if your loan provider uses the weighted average method, because it may not help you at all. Instead, it just puts their assets at risk.

Alternatives to Getting a Business Loan Cosigner

Because a cosigner is taking on such a large financial risk with your business, it may be difficult to obtain one. If you are unable to secure a cosigner, think about the alternatives available to you.

Improve Your Credit

Improving your credit should be a priority as a business owner. It helps not just with bank financing but with supplier credits and revolving credit often needed to run your business. When possible, a business should be seeking to establish its own creditworthiness to be able to qualify for financing without personal guarantees.

If your credit is lower than you want it to be, then you typically fall into one of two areas:

• Credit repair needed: You may need help removing errors on your credit report or paying down debt. It’s important to get your utilization ratio down to under 33%.
• Build credit history: If your credit is thin, you likely need to open new accounts to establish credit. You can do this by opening secured credit cards, fuel cards, or small business credit cards.

Establishing and repairing credit takes time. If you know you’ll be seeking financing in the future, it’s best to get an early start on your own credit profile to give yourself the best chances of getting approved for funding. A credit repair company can help you remove unwanted derogatory marks on your credit—often faster than doing it on your own.

Bad Credit Business Loan

A bad credit business loan is an alternative if you need money sooner-than-later but don’t have stellar credit or a cosigner. These loans might be an only option for some businesses but can feel like you’re dealing with a loan shark in the process.

Typical bad credit business loans:

• Are more expensive: These loans are more expensive than traditional loans, with higher interest rates and shorter terms than traditional financing―30% to 80% annual percentage rate (APR).
• Don’t require a cosigner or collateral: They are easier to get, often not requiring a cosigner or collateral.
• Leverage recent results: You can leverage recent revenue, your receivables, or consistent credit card sales.
• Loan amounts up to $500,000: While many bad credit business loan borrowers get loans for less than $100,000, you can get approved for amounts as high as $500,000.

While the lender requirements are much looser for bad credit loans, expect to show a minimum FICO score of 500.

What a Business Loan Cosigner Needs to Know

Getting a loan cosigner can be very helpful ,and it’s a frequent practice. In fact, one in six of all United States adults have cosigned a loan―either personal or business―for someone they know. However, if you’re the one looking to be a cosigner for someone else’s loan, then there are some things you should be aware of before you jump in. Being a cosigner is risky.

According to a recent study, which analyzed cosigners for all loans―personal and business:

• 28% of cosigners see a drop in their personal credit scores because the primary borrower paid late, or they didn’t pay at all.
• 38% of cosigners ended up having to pay some or all of the loan payments.
• 26% of cosigners say that the total experience damaged the relationship with the person they cosigned for.

If you’re thinking about becoming a cosigner on a business loan for a friend or family member, consider the risks to your credit and financial accounts. Understand what you are on the hook for and what will be required of you in the process of cosigning any business loan.

Promise to Repay

A cosigner is making a promise to repay the loan if the borrower defaults. This means you could be the hook for a large amount of money, or your personal assets could be on the hook if the borrower defaults, and you can’t make the payments.

No Bank Notification of Default Is Required

The bank is not required to inform a cosigner if a loan is in default. This means that you could assume everything is going fine with the business and loan terms and suddenly find yourself answering mail and phone calls from debt collectors. It is possible that by the time you find out about the collection, derogatory marks have already hit credit reports.

Collateral Typically Required by Cosigner

It’s normal practice on a business loan application for a cosigner to be required to provide collateral, which can be seized and sold in the event of a default.

Cosigner’s Credit Will Be Checked

A cosigner’s credit will be checked during the due diligence stage of the loan application, and each cosigner will be responsible for providing a personal financial statement. This means that there will be a hard credit pull that can adversely affect credit ratings and the ability to obtain personal financing.

You Might be Responsible for Additional Fees

Any fees tacked on to the collection of the debt will often be the cosigner’s responsibility as well. These fees include, but aren’t limited to, late charges, fines, and penalties above the loan obligation.

When agreeing to become a cosigner, make sure you have reviewed the business plan and marketing strategy as well. While you may trust the person you are helping, you should take an interest in the business to be certain you are not taking on a bad risk. After reviewing the business scenario, you might feel your interest is served better as a partner in the business rather than merely a cosigner responsible for the debt. Whichever the case, do your due diligence.

Bottom Line

When seeking financing for your business, you may have no option but to get a cosigner. If you do need one, make sure you have properly shared the requirements with them and help them understand the commitment they are making to your business. In the interim, check your credit score and see if a small improvement or larger down payment might eliminate the need for a cosigner.