When you took out a student loan to pay for school, you probably didn't expect it to go into default. But more than 1 million federal student loan borrowers default each year, according to the Urban Institute, a think tank focused on economic and social policy research.
If you're in over your head, you can settle student loan debt for less than what you owe, provided the lender agrees to do so. But first, consider the ramifications to your credit, taxes and other areas of your life. Here's what you need to know about student loan debt settlement.
What Is Student Loan Debt Settlement?
A debt settlement is an agreement a lender can make with a borrower to accept less than what was originally owed as full payment. It's different from loan forgiveness and discharge, which cancel the balance under special circumstances.
Student loans can generally be settled, but a loan typically has to be in default. A lender isn't likely to accept less than what you owe if it has reason to believe you'll continue making payments.
"If you're making payments on your loan, and everything is in good standing, you're not going to be able to just call your loan servicer up and say, 'Hey, will you take 50 percent?'" says Adam S. Minsky, an attorney specializing in student loan debt.
Your loan is considered delinquent as soon as a payment is late, but it may not be considered in default just yet. Default on most federal loans is when the borrower has missed payments for 270 days, or about nine months. But a Perkins loan could be considered in default after the first missed payment.
Private student loans are granted by banks and other institutions outside of the federal loan system. With these loans, default depends on the lender, but it is usually when payments are around three months overdue.
How Student Loan Debt Settlement Works
Your options are different for federal and private student loans, but debt settlement follows a similar three-step process for both:
-- Step 1. Approach the lender about debt settlement.
-- Step 2. Negotiate the debt settlement.
-- Step 3. Pay the agreed-upon amount.
Approach the lender about debt settlement. Uncle Sam owns your federal student loan and, consequently, has some powerful tools to demand repayment. When your federal loan is in default and you haven't made repayment arrangements, the servicer may send the loan to a collection agency. The loan holder may withhold your tax refund and Social Security benefits, garnish up to 15 percent of your disposable pay, and take your driver's license -- without going through court first.
Moving your loan to a collection agency usually incurs fees, which are added to the amount you owe. Contact your loan servicer to ask about your options. You can find out who services your loan by logging in to My Federal Student Aid.
Collection agencies have the authority to approve three standard settlement options. For any other arrangements, the agency needs approval from the U.S. Department of Education. Collection agencies can approve:
-- Payment of the entire principal balance, plus accrued unpaid interest, with waived collection charges.
-- Payment of the total principal, plus half your interest balance. The other 50 percent of the interest will be forgiven.
-- Payment of 90 percent of the total balance, including principal and interest.
When a private student loan is unpaid, the servicer will contact you and your co-signer, if you have one, to try to get payment through a series of phone calls and letters. The lender can also take legal action against you, although it has a limited number of years to sue you to collect, called the statute of limitations. If the lender successfully sues and gets a court order to pursue collections, it can garnish your wages or get a lien on your home.
If your private student loans are in collections, you have a few main options. You can pay the entire bill, negotiate a payment plan or try to settle the debt.
"You typically get a much better deal with private student loan settlements than you do with federal student loan settlements," says Stanley Tate, a student loan lawyer. For example, Tate says he settled a client's $68,000 federal student loan debt for $55,000 and a $61,000 private student loan balance for $26,000. In Tate's experience, borrowers may be able to negotiate a payment that's 30 to 60 percent of the original balance, either as a lump sum or an installment plan.
But finding enough money to pay off the amount owed may be difficult for borrowers already in financial distress. Be sure you can access the money before you start negotiating.
Negotiate the debt settlement. A collection agency is hired to get the largest payment it can from delinquent borrowers, so negotiation is essential in the debt settlement process. Borrowers can hire an attorney, enter a plan with a debt settlement company or negotiate a settlement independently.
[Read: Best Private Student Loans.]
Consider the cost of hiring an attorney or a debt settlement company when deciding if debt settlement is the right choice for you. Debt settlement companies and attorneys typically charge a fee that is a percentage of the debt balance or how much they saved you. By law, debt settlement companies can't charge you until the debt is settled, and they must disclose all terms in writing upfront.
Going the DIY route is possible too, but Tate says borrowers should be careful with information they divulge to the loan holder. For example, instead of sharing your savings account balance and that you have a 401(k), simply tell the lender what you can afford. "You don't want to give them information unnecessarily," Tate says.
Although the cost of hiring someone could add to the final amount you pay, you may decide that letting an experienced professional lead you through the process and negotiate on your behalf is worth it.
Pay the agreed-upon amount. Get the settlement deal in writing, along with a receipt when you pay. And keep copies of both in case you need to prove the loan is paid in full.
"Once the settlement is agreed to, I always require that the lender or debt collector provide the offer in writing with the specific terms, amounts and deadline for the payment, and confirmation that the balance will be considered paid in full," Minsky says.
The federal government will expect you to make good on the lump-sum payment within 90 days of the settlement agreement date. A private loan settlement may come with different payment terms, but Tate says borrowers can negotiate either a lump sum or an installment payment.
Consequences of Student Loan Debt Settlement
Settling student loan debt can help relieve your financial stress, but you may need to deal with consequences such as damage to your credit rating and tax implications. Here's what you need to know about the aftermath of a settlement.
Your credit score will take a hit. Whether private or federal, a student loan may negatively affect your credit while it is delinquent and once it is settled.
Delinquent federal student loans are reported to the credit bureaus after 90 days of missed payments, and private student loans may be reported to the bureaus as soon as they're late. According to Urban Institute research, borrowers who are late on payments see their scores drop by an average of 50 to 90 points before they finally reach loan default. Furthermore, if you have a co-signer, his or her credit will also take a hit. A damaged credit history may affect your ability to get a mortgage, pass an employment credit check or obtain approval for an apartment lease.
Once you settle the student loan debt, the account will be reported as settled or noted as paid for less than the full balance. The settled status will stay on your credit history for up to seven years from the date the account became delinquent.
You'll owe taxes. Any debt that was canceled in the settlement is generally considered taxable income, according to the IRS. If your loan balance was reduced from $60,000 to $40,000, then you'll owe taxes on the $20,000 that was canceled.
Talk with a tax adviser, get free tax help from the IRS or visit a taxpayer clinic. You may qualify for an insolvency exemption that allows you to exclude the canceled debt from your gross income, Tate says. But if you don't qualify, then get an estimate of how much you'll owe. Factor taxes into how much your settlement will cost, and make sure you can pay the bill.
"You don't want to exchange one debt for a debt with the IRS that you can't pay," Minsky says. "It doesn't leave you in a good position."
Alternatives to Student Loan Settlement
Debt settlement isn't your only option when your payments get off track. Among borrowers who default on student loans, 70 percent can get out of default within five years, according to the Urban Institute. More than 30 percent fully pay off their defaulted loans in that time frame.
If your loan is in default, you'll need to restore it first. There's no central program for private student loans, so rehabilitation options will depend on your lender. For federal student loans, the Department of Education offers clear paths for how borrowers can exit default. Borrowers can pay off their debt in installments or a lump sum, set up a loan rehabilitation agreement and make nine consecutive monthly payments, or combine all their loans with a new direct consolidation loan.
Consider some of these alternatives to student loan debt settlement:
Income-driven repayment plans. Federal student loan borrowers can enter repayment plans that set their monthly payment as a percentage of income. That's as long as the loan is not in default. If your income is low enough, your monthly payment can be zero dollars.
Deferment or forbearance. These options are available for federal student loans and may be offered through your private student lender. They allow borrowers to temporarily reduce or stop loan payments. Depending on the loan, you may not have to pay interest accrued when a loan is in deferment. But typically, you'll have to pay accrued interest when a loan is in forbearance.
Student loan forgiveness. Federal student loan borrowers may be eligible for student loan forgiveness programs. Programs may be available based on your profession, state or employer.
Private lender hardship options. Talk with your private student lender about hardship programs. A nonprofit organization such as the National Foundation for Credit Counseling may be able to help you figure out what you can pay and offer tips for communicating with your lender. Borrowers should bring a clear summary of their finances and ideas for how they can get their payments back on track.
Refinancing. Generally, refinancing federal student loans into new private student loans is not a good idea, but you might be able to make payments on private student loans more affordable with refinancing. If you can qualify for an offer with a lower interest rate than your current loans, refinancing can help you reduce your monthly payments.
Although debt settlement is possible for private and federal student loans, your credit may be damaged in the process, and you may owe taxes on the forgiven debt. Other options, such as establishing a loan rehabilitation agreement, entering an income-based payment plan and discussing hardship programs with your private lender, may help you avoid default or debt settlement.
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