Borrowers who have defaulted on federal and private student loans may be able to get a settlement of their loans for less than what they owe, if they have the cash to make a lump sum payment. Borrowers who are unable to make a lump sum payment may be able to get a modified payment plan.
A settlement is different than student loan forgiveness or a discharge of student loan debt. Loan forgiveness cancels student loan debt in exchange for working in a particular occupation, such as teaching in a shortage area. Discharge cancels student loan debt because of an inability to repay the debt due to death, disability or bankruptcy or because the debt was not authorized by the borrower because of identity theft or false certification.
Borrowers who cannot afford to make a lump sum payment but need some financial relief have other options. For a short-term financial difficulty, borrowers might consider a deferment or forbearance. These are temporary suspensions of the obligation to repay the debt, but interest may continue to accrue, increasing the size of the debt. For a long-term financial difficulty, borrowers might consider using an alternate repayment plan, such as income-based repayment or extended repayment. These repayment plans reduce the monthly payment by increasing the term of the loan, but may also increase the total interest paid over the life of the loan.
Standard Settlement Offers for Federal Loans
Collection agencies may offer a borrower one of three standard settlements on defaulted federal student loans without needing to get approval from the U.S. Department of Education:
- Waiver of collection charges. Collection charges of up to 20 percent are subtracted from any voluntary or involuntary payments on defaulted student loans. This increases the payoff amount by up to 25 percent of the loan balance. A waiver of the collection charges reduces the payoff amount to the amount owed.
- Forgiving half of the interest balance. Interest continues to accrue after a borrower defaults on his or her loans. An extended period of non-payment can significantly increase the size of the loan. Waiving half of the interest that has accrued since the loan entered default effectively splits the difference between the current loan balance and the loan balance when the loan went into default.
- Discount the loan balance by up to 10 percent. This reduces the principal and interest balance by up to 10 percent.
Almost all other settlements require prior approval by the U.S. Department of Education. Non-standard settlements are extremely rare. (Collection agencies can make a handful of non-standard settlements per quarter without prior approval, but must compensate the U.S. Department of Education for the difference between the non-standard settlement and the standard settlements. This will reduce or eliminate the collection agency’s commission.)
Collection agencies are paid on commission and will seek the highest settlement amount.
There are a variety of other restrictions on settlement offers:
- Collection agencies almost never settle defaulted loans for less than the amount of the default claim paid by the U.S. Department of Education when the loans went into default.
- Before making a settlement offer, the collection agency will calculate the net present value of all anticipated future voluntary and involuntary payments on the debt. The settlement offer must be greater than this amount.
- Collection agencies require full disclosure of the borrower’s financial circumstances. They want to understand how the borrower will be able to pay the settlement.
- Debts relating to fraud are never settled.
- If the U.S. Department of Education sued the borrower and obtained a court judgment against the borrower, the U.S. Department of Education is unlikely to approve a settlement.
Strategic Default Is Not Effective
Strategic default occurs when a borrower decides to stop making payments on a loan despite being able to make the payments.
Strategic default is not an effective method for reducing the amount of a borrower’s debt. Few defaulted borrowers succeed in obtaining a settlement. The amount of the settlement is usually much higher than the loan balance at the time of the default.
There are also many penalties for defaulting on federal student loan debt. The federal government has very strong powers to compel repayment of defaulted federal student loans. The government can garnish up to 15 percent of the borrower’s income (after amounts required by law to be withheld are subtracted), intercept federal and state income tax refunds and offset up to 15 percent of Social Security benefit payments. The federal government can prevent the renewal of professional licenses. Defaulted borrowers may not enlist in the U.S. Armed Forces. Interest continues to accrue after default and will be capitalized if unpaid. Collection charges of up to 20 percent will be deducted from every payment before the remainder is applied to the interest and principal balance of the debt. The borrower’s credit will be damaged, making it difficult to obtain credit cards, auto loans and mortgages. Borrowers who have defaulted on federal student loans are ineligible for FHA and VA mortgages. They may even find it difficult to rent an apartment or get a job, as some landlords and employers will check their credit history. The federal government can sue the borrower to get a judgment and seize the borrower’s assets to repay the debt.
Cancelled Debt May be Treated as Income
If the cancelled debt is $600 or more, the lender will send the borrower an IRS Form 1099-C. Cancelled debt is usually treated as taxable income. This can leave the borrower with a big tax bill.
There is, however, an exception when the borrower is insolvent (total debts exceed total assets). Depending on the borrower’s circumstances, all or part of the cancelled debt may be excluded from income. The amount of the exclusion is capped at the excess of the borrower’s debt over the borrower’s assets. See IRS Form 982 and IRS Publication 4681 for additional information. Borrowers who have had debt cancelled should consult with their tax preparer or accountant for advice specific to their situation.
Borrowers who do not qualify as insolvent may be able to negotiate a settlement with the IRS concerning the tax debt. Submit an offer in compromise using IRS Form 656.
Lump Sum Payments
A lump sum payment is a single payment, not an extended series of installment payments. In most cases, the lump sum payment must be made within 90 days of the settlement approval. Lump sum payments can be split into a few large installments, but generally, for settlements of defaulted federal student loans, all of the payments must be made within the same federal fiscal year, which ends on September 30.
Finding the cash to make a lump sum payment can be difficult for most defaulted borrowers. Some of the more common sources of funding include:
- A hardship distribution from the borrower’s retirement plan
- A loan or gift from friends and family
- Parents using a home equity loan to pay off a child’s defaulted student loans
- Big bonus from the borrower’s employer
- Winning the lottery
Student loan settlements must generally be paid by a cashier’s check, certified personal check, money order, or credit card.
Impact on Credit Scores
A settlement offer does not affect the borrower’s credit, but an actual settlement will damage the borrower’s credit. However, a settlement will be less damaging to the borrower’s credit than an ongoing delinquency associated with a defaulted loan.
There are degrees of damage to the borrower’s credit history. A settlement is looked upon more favorably than a charge-off or court judgment, in that it demonstrates a voluntary effort by the borrower to cooperate with the lender.
Credit scores are supposed to be predictive of the likelihood of the borrower paying back a debt on time as per the agreement. A settlement is only a partial pay-back. This will make it more difficult for the borrower to get new credit.
A settlement does not normally clear the default status of the loan. However, some borrowers might ask the lender to remove the default status as part of the settlement agreement. The borrower can also ask the lender to report the settlement as “paid in full” instead of “settled debt.” But the past delinquencies will still persist in the borrower’s credit history.
The main benefit of a settlement is that it eliminates the new delinquencies, which can be very harmful to the borrower’s credit score. (This assumes, of course, that the borrower repays his or her other debts on time as per the agreement.) If there are no new delinquencies, the borrower’s credit scores should improve with time and responsible credit behavior.
Settling a debt can affect the borrower’s credit scores in other ways, both positive and negative. It reduces the borrower’s debt-to-income ratio, which can improve the credit scores. On the other hand, settling a debt does close the account, which will reduce the average length of the borrower’s credit history. This may cause a decrease in the borrower’s credit score.
Final Tips for Student Loan Settlements
Get the settlement agreement in writing before making any payments toward the settlement.
Before agreeing to a student loan settlement, review it to ensure that it is settling all of the debts that the borrower believes are being settled. Some borrowers have sought settlements of their federal and private student loans, but later discovered that the settlement covered only one type of loan.
Make sure that the written settlement agreement will provide the borrower with a “paid-in-full” statement after the settlement is paid. Some borrowers thought they were settling their student loans, only to discover later that the collection agency applied the payment to the debt without settling the debt.
Beware Zombie Debt
Student loan debt has a nasty habit of resurrecting itself years or even decades after the settlement. The lender might hire a new collection agency, restore an old backup tape, or fail to properly record the settlement on its books. Borrowers should keep their “paid-in-full” letters , statements and other written documentation indefinitely, as otherwise it can be difficult to prove that the debt was settled.
Other Resources for Settling Federal Education Loans
Borrowers who are unsure who to contact may find their servicer on the web site of the National Student Loan Data System (NSLDS), www.nslds.ed.gov.
The Federal Student Aid Information Center (FSAIC) may also be able to help. They can be reached at 1-800-4-FED-AID (1-800-433-3243).
There are several other resources at the U.S. Department of Education that may be helpful to borrowers who are seeking a settlement: