If I Stop Paying My Student Loans, Will the Default Yield a Reasonable Settlement?
September 05, 2011
Options for Relief
Student loans are a form of indentured servitude without many opportunities for relief. Offers to settle your student loan debt for less than what you owe are as rare as hens teeth. Even if you get a settlement offer, it will still end up costing more than you would have paid if you hadn’t defaulted. While your loans are in default, interest continues to accrue, digging you into a deeper hole. Few defaulted borrowers are able to climb out of this hole, since a settlement requires a lump sum payment on a debt that may greatly exceed the amount originally borrowed. The standard settlement offers on defaulted federal education loans do not provide complete absolution. Instead, they may involve a waiver of the collection charges, cancellation of half of the accrued but unpaid interest or a 10% reduction in the total principal and interest balance. Like Shylock, the federal government still demands a pound of flesh.
However, there are a few incantations that perhaps can end the defaulted borrower’s torment.
The Fair Debt Collection Practices Act (FDCPA) prohibits collection agencies from harassing defaulted borrowers. The Federal Trade Commission, which enforces the law, publishes a good guide to debt collection and the FDCPA which will tell you how to exercise your rights under the law to stop the harassment. You’ll still owe the money, but the collection agency won’t be able to contact you except to tell you about specific actions it is taking with regard to your debt.
Borrowers of federal education loans have a one-time opportunity to remove a default from their credit record by rehabilitating the loans. This involves making 9 out of 10 consecutive on-time full voluntary monthly payments on all the loans, often on top of any involuntary payments. The voluntary payments are supposed to be “reasonable and affordable”, but defaulted borrowers must be persistent to get the payments reduced to a tolerable level of pain.
After the loans are rehabilitated, borrowers can choose to repay their loans under the income-based repayment plan, which bases the monthly payments on a percentage of the borrower’s discretionary income. This often yields monthly payments that are lower than the wage garnishment amount.
Unfortunately, private student loans do not offer a similar option for relief. Income-based repayment is not available for private student loans. If most of the loans are private, even income-based repayment on the federal loans may not provide much relief, since obligations from non-federal debt are not considered.
Borrowers with a debt-to-income ratio of 2 to 1 or greater are at very high risk of default. Fundamentally, there are only a handful of options for avoiding default. One is to increase income by getting a better-paying job or by working two jobs. Another is to qualify for some form of loan forgiveness. For example, federal student loans may be eligible for public service loan forgiveness (e.g., working as a teacher, for the government or for a tax-exempt charitable organization). Another is to find a way to decrease the monthly loan payment, perhaps by refinancing one or more of the loans into a loan with a lower interest rate. The main option when the borrower’s credit score is too low to refinance at a lower rate is to seek help from a relative. Finally, borrowers in financial distress should undergo a budgeting exercise, to see if there are any ways to cut spending or sell extraneous possessions to accelerate repayment of the debt with the highest interest rate.