06/07/2012 04:42 pm ET

'No More Mr. Nice Guy' - Why You Should Think Twice Before Co-Signing a Loan

She was in tears as she sat in my office. Her credit report looked bleak because of a loan that was in default. When I asked her about it, she said it wasn't even hers: "I just co-signed it for my brother because he couldn't get the loan himself. I'm not sure why it's on MY credit report!"

I can't tell you how often I see that situation happen: A borrower doesn't have the credit to get a loan themselves so a well-meaning friend or family member offers to help by co-signing the loan... only to have it come back to haunt their credit reports when the loan doesn't get paid. It happens over and over again because people don't realize one critical truth of co-signing:

When you co-sign a loan, it's as if you took out the loan yourself. Therefore, it has the same impact on your credit.

Here's why lenders sometimes require co-signers: Lenders are in the business of lending money but they want the money paid back to them. If a borrower's credit score is too risky in the lender's opinion, the lender requires other assurances that the money will be returned.

That's where a co-signer comes in.

A co-signer isn't just "vouching" that the other person will pay the loan back (which is how a lot of people mistakenly think of co-signing). Instead, the co-signer is signing the loan documents and agreeing to have their good credit score be used in place of the other borrower's bad credit score. AND the co-signer is agreeing to make sure the loan gets paid back (whether that means the other borrower pays it back or they do). In the eyes of the lender and the credit reporting agencies, a co-signer IS a borrower.

So if you have someone ask you for help by co-signing a loan, what should you do? Here's what I suggest:

First, only co-sign for people you trust. Remember that this loan will appear on your credit report as a good loan and (if it doesn't get paid) as a bad loan. If you don't want to co-sign for someone, don't be afraid to say no. I understand the pressure of wanting to help out a friend or family member but their financial troubles could quickly become your financial troubles if they are unable to pay back the loan. The short term discomfort of saying "no" to someone is far better than the long-term discomfort that will result if the loan defaults, hurts your credit score, and causes your relationship to sour.

Second, treat the loan as if it were you were borrowing the money for yourself. Figure out how the loan will get paid back and set up a budget with the other person. Make sure you can afford the payments if the other person is suddenly unable to pay. Perhaps even ask the other borrower to pay you so you can pay the lender; that way, you know it's getting paid on time. Insist that you get a copy of the statements. Many co-signers say that they never got the late-payment notices and didn't know the loan was going into default, so be proactive and ask up-front to have all loan documentation sent to you.

Co-signing can be a great way to help a responsible family member or friend who has fallen on hard times and needs a hand to get back on their feet. But co-signing comes with consequences that you should be aware of before you sign any papers!

When co-signing, think like a borrower and treat the loan as if it were your own.