Is it worthwhile to let my student loans go into default to get a settlement?

Question:

I graduated with an above-average amount of student loan debt, but I got a good job and am able to afford the monthly loan payments. However, I recently came into some money, totaling about half of what I owe on my student loans. Is there anything I can do to get the lender to accept this as payment in- full on my loans? I read that sometimes lenders will settle a borrower’s student loans for less than the amount owed, if the borrower is in default. Is it worthwhile to let my loans go into default to get a settlement?

Answer:

As a general rule, lenders do not settle non-defaulted student loans for less than what is owed. The payoff amount on a student loan equals the total outstanding loan balance, including the principal balance and any accrued but unpaid interest.

There is no reason why a lender would want to settle a debt that is in good standing for less than what is owed. Lenders prefer to be repaid over time, as opposed to receiving a lump sum payment, because they earn interest when a loan is repaid over time, but not when the debt is paid off early. Moreover, if a lender accepts a lump sum payment that is less than the principal balance, the lender loses money on the loan.

Lenders do, occasionally, settle defaulted loans for less than what is owed. But, these settlements are almost always for an amount that is greater than the amount owed at the time the loan entered into default. Such student loan settlements are mainly waiving additional charges, such as collection charges, and not the principal balance of the loan. When the borrower has been in default for a very long time, sometimes the lender will agree to forgive up to half of the interest that has accrued since the loan entered into default. So, even when a defaulted borrower is able to obtain a settlement, it is not for pennies on the dollar.

Net Present Value: The net present value is an equivalent current value of a future series of cash flows.

Strategic default, where the borrower intentionally defaults on a loan in the hope of negotiating a settlement, will not save the borrower any money. Lenders never settle student loan debt when the borrower is capable of repaying the debt. Before a lender will agree to settle student loans for less than what is owed, the lender will want full disclosure of the borrower’s finances and the source of the settlement payment. The settlement amount will almost never be less than the net present value of the future payments the lender can expect to receive on the loan.

The federal government, in particular, has very strong powers to compel repayment on defaulted federal education loans, so there is little reason for the government to accept a settlement offer. If a borrower is in default on a federal education loan, the federal government can garnish up to 15 percent of the borrower’s wages and intercept federal and state income tax refunds, without a court order. The debt does not disappear when the borrower retires, so the federal government can offset up to 15 percent of Social Security benefit payments to repay defaulted loans. Collection charges of up to 20 percent are deducted from loan payments before the remainder is applied to the interest and principal balance of the debt.

Private lenders must sue the borrower and obtain a court judgment before they can garnish the borrower’s wages, but then they can also place liens against the borrower’s assets and use a levy to seize some of the borrower’s assets to repay the debt.

Both federal and private student loans are almost impossible to discharge in bankruptcy, so borrowers cannot use the threat of a bankruptcy filing as leverage to negotiate a settlement.

There are several unusual situations in which the borrower’s student loan debt might be discharged. For example, if the college closes while the student is enrolled or within 120 days of the student’s withdrawal from the college, the student’s federal student loans at that college may be eligible for a closed school discharge. If the borrower becomes totally and permanently disabled, the borrower might be eligible for a disability discharge on his or her federal student loans. Four private lenders offer a similar disability discharge on their private student loans. There are also loan forgiveness programs available to federal student loan borrowers who work in particular professions, such as public service or teaching.

Although some policymakers have called for forgiving or refinancing some or all student loan debt, none of these proposals have been successful to date.