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Secrets to Settling Defaulted Federal Student Loan Debts for Less than What You Owe

Mark Kantrowitz

June 30, 2010

Your federal student loans are in default and collection agencies are calling you dozens of times a day. They are threatening to garnish your wages, offset your income tax refunds and ruin your credit. They may even have crossed the line into harassment, calling you a worthless person and threatening you with physical harm. Are there any ways of getting out of this mess?

Bankruptcy discharge is not a good option, as less than 1% of students with active bankruptcies have succeeded in getting their student loans discharged in bankruptcy. Current law requires borrowers to demonstrate undue hardship in an adversary proceeding, and each judge interprets the law differently. Even if you succeed in obtaining a bankruptcy discharge, it will ruin your credit for seven years. Congress has proposed repealing the exception to discharge for private student loans, but federal student loans will still be excepted from discharge even if the law is enacted.

The Fair Debt Collection Practices Act (FDCPA) is a useful tool for ending harassment by bill collectors, but it doesn’t provide financial relief. You still have to repay the debt, and the lender can still garnish your wages, file a lawsuit and take other actions to collect the debt. They just can’t contact you to demand repayment.

There are, however, two good tools for addressing your debt: settling your debt for less than what you owe and obtaining an affordable repayment plan.

Settling Your Debt

To settle your defaulted debt, you must be able to make a lump sum payment to pay off most of the loan balance. Such a compromise offer will typically require you to pay the settlement amount in full within 90 days. The most common circumstances in which a defaulted borrower will be able to make a lump sum payment include receiving an inheritance, getting a big bonus at work or winning the lottery. Sometimes your family will lend you money to help you pay off the defaulted loans and get more favorable terms on the debt.

The key to getting a good settlement is knowing the settlement options available to the collection agency. The US Department of Education allows private collection agencies to make three kinds of settlements without prior approval:

1. Waiver of the collection charges (the borrower pays only the current principal and accrued but unpaid interest).

2. Payment of the current principal balance plus half of the accrued but unpaid interest.

3. Payment of at least 90% of the current principal and interest balance.

If you offer less than these standard compromises, the collection agency will need to get approval from the US Department of Education and may lose all or part of its commission. Non-standard compromises are not very common because of this.

If you obtain a settlement, get the settlement offer in writing and have it reviewed by an attorney. Make sure that the settlement indicates that it will satisfy all the debts in full and that you receive a “paid in full” statement after you have paid the compromise amount. Otherwise the debts could resurface years later and you won’t be able to prove that they were satisfied in full.

See Student Loan Debt Settlements on the FinAid site for additional information.

Affordable Repayment Plans

If you can’t afford to make a lump sum payment, talk to the current holder of the loan about getting an affordable repayment plan. Federal student loans, for example, offer income-based repayment as an option. This repayment plan bases your monthly payments on a percentage of your discretionary income, not the amount you owe, and the remaining debt is forgiven after 20 or 25 years in repayment. For most borrowers this will result in a monthly payment that is less than 10% of gross monthly income. The monthly payment is zero for borrowers who earn less than 150% of the poverty line.

However, before you can obtain income-based repayment, you may be required to rehabilitate your student loans. This is a one-time opportunity to clear the default. It involves making nine out of ten consecutive on-time full voluntary monthly payments, typically about 1.0% of the current outstanding principal and interest per month. Voluntary payments do not include payments made through wage garnishment or income tax refund offsets.

In some cases a borrower may be required to consolidate the loans and collection charges of up to 18.5% of the amount owed may be added to the loan balance. Some defaulted borrowers resist this because it effectively reaffirms the debt, including debt they they may feel is not legitimate. For example, the loans may have gone into default because the lender refused to grant an economic hardship deferment or forbearance. There may be accounting errors such as a failure to record some payments properly or incorrect calculation of interest or collection charges.

But rather than stand on principle, it’s sometimes better to just go with a practical solution that will save you money. The monthly payment under income-based repayment is usually lower than the monthly payment under administrative wage garnishment for low and moderate-income borrowers and for borrowers with larger families. So even with the collection charges you will probably save money by rehabilitating the debt and seeking income-based repayment.


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