Borrowers who rehabilitate a defaulted federal education loan may regain some of the benefits that were lost when the borrower defaulted on the loan, such as eligibility for further Title IV federal student aid as well as the borrower’s remaining eligibility for loan deferments and forbearances. Rehabilitating a defaulted student loan can also remove the default from the borrower’s credit history.
Criteria for Rehabilitation
Rehabilitation involves making a number of consecutive, voluntary payments on the defaulted loan. The payments must satisfy the following criteria:
- Voluntary. These payments must be in addition to any involuntary payments. Voluntary payments do not include payments made through wage garnishment or U.S. Treasury offset of federal and state income tax refunds.
- On-time. On-time payments are made within 15 or 20 days of the due date, depending on the type of rehabilitation.
- Reasonable and Affordable. The monthly payments must be made as part of an agreement between the borrower and the guarantee agency or the U.S. Department of Education. The required payments should be reasonable and affordable, based on a review of the borrower’s total financial circumstances, including consideration of the borrower’s disposable income and reasonable and necessary expenses for the borrower and the borrower’s dependents. Disposable income includes income from all sources after subtracting amounts required by law to be withheld.
- Full. The monthly payments must be the full amount specified in the agreement. Partial payments do not count as satisfying the requirements for rehabilitation.
- Monthly. There must be a series of consecutive payments to rehabilitate the loans. Paying off the debt in full with a lump sum payment does not count as rehabilitating the loans, although it will restore eligibility for Title IV federal student aid.
Payments missed while the borrower is an ^&*affected individual*&^ under the HEROES Act are not treated as an interruption in the number of consecutive on-time payments required for rehabilitation.
If the borrower has been sued and a judgment issued against the borrower, the defaulted loan is not eligible for rehabilitation.
Three Types of Rehabilitation
There are three types of rehabilitation, depending on the number of consecutive monthly payments.
In addition, since July 1, 2010, borrowers may consolidate a defaulted loan into the Federal Direct Loan program without rehabilitating the loan first, if they agree to repay the loan under the Income-Contingent Repayment (ICR) or Income-Based Repayment (IBR) plans or if they make satisfactory repayment arrangements with the current loan holders. However, this consolidation option does not remove the default from the borrower’s credit records, so borrowers may prefer to rehabilitate the loans by making 9 out of 10 consecutive, on-time, full, voluntary monthly payments, which does remove the default from the borrower’s credit history. Since July 1, 2014, borrowers are allowed to make the monthly payments under income-based repayment, provided that the monthly payment is at least $5 a month.
Collection costs of up to 18.5% of the principal and interest balance of the loan may be added to the loan balance when a defaulted Federal Stafford loan, Federal PLUS loan or federal consolidation loan is rehabilitated. Collection costs of up to 24% of the principal and interest balance of the loan may be added to the loan balance when a defaulted Federal Perkins loan is rehabilitated. (The 24% cap does not apply if the borrower defaults on a rehabilitated Federal Perkins loan.) Collection charges are then no longer deducted from payments on the rehabilitated loan.
It may take as long as 75 days (30 days for rehabilitated Federal Perkins loans) after the borrower has satisfied the requirements for rehabilitation for the loan default status to be removed from the borrower’s credit history.
The borrower must continue to make on-time payments to retain eligibility for federal student aid. Rehabilitation is a one-time opportunity to return the loan to a regular repayment status, for loans rehabilitated on or after August 14, 2008. If the borrower defaults again, the borrower will not be able to rehabilitate the loans again. (However, if the borrower consolidates a rehabilitated loan and the borrower defaults on the new consolidation loan, the borrower will be eligible to rehabilitate the defaulted consolidation loan.) The only option will then be to pay off the loan in full.
Negotiating with Collection Agencies and Guarantee Agencies
Collection agencies and guarantee agencies are paid on commission. This puts pressure on them to seek the highest possible monthly payment from the borrower. Specifically, they will earn their full commission if the monthly payment exceeds a certain percentage of the outstanding loan balance:
For example, if a borrower owes $25,000 in Federal Stafford loans, the monthly payment would need to be at least 0.87% of $25,000, or $217.50. This is lower than the monthly payment under a standard 10-year repayment plan, but more than the monthly payment under a 20-year repayment term.
Effective July 1, 2014, the U.S. Department of Education considers the starting point for a reasonable and affordable monthly payment to be 15 percent of the amount by which the borrower’s adjusted gross income (AGI) exceeds 150 percent of the poverty line (based on the borrower’s family size and state), divided by 12. This amount is rounded up to $5 if it is less than $5. This is similar to the monthly payment under income-based repayment. Borrowers who accept this starting point are not required to provide documentation of their financial circumstances by completing the Financial Disclosure for Reasonable and Affordable Payments form. However, the borrowers will be required to provide documentation of income and other information necessary to calculate the monthly payment.
Borrowers who are unable to afford these monthly payments should reject the first offer and insist on a having a reasonable and affordable monthly payment based on the borrower’s total financial circumstances. A reasonable and affordable monthly payment may be lower than the minimum payment on the loan, if justified by the borrower’s total financial circumstances. It may even be lower than the new interest that accrues on the loan.
Collection agencies and guarantee agencies often do not mention the availability of income-based repayment as an option for similar reasons, since the lower monthly payment under income-based repayment leads to a lower commission on collecting the rehabilitated loan.