It's pretty clear that student loans are becoming a crisis. As a matter of fact, a recent study found that there are over 600,000 people who owe greater than $200,000 in student loans. You may be reading this and owe two or three times that amount, so it doesn't come as a surprise to you. And it also wouldn't surprise you that when faced with these mountainous debts, many borrowers choose to simply bury their head in the sand and not address their student loans. That may sound like a great option at times, but unfortunately it leads to some pretty hefty consequences. One of those consequences is potentially defaulting on your loans, which can have a big impact on not just your loans, but other areas of your finances as well. So today, in case you've already found yourself in a situation where you've defaulted on a loan, we're going to go over three ways to pull yourself out of the mud. And if your loans aren't in default ... don't let them go into default!
Before we cover the three areas, it's important to distinguish a delinquent loan from a defaulted loan.
Delinquent Loans
Technically, your loan is considered delinquent. But once your federal student loan payment is more than 90 days late, your loan servicer reports the delinquency to all three credit bureaus, which would definitely do some damage to your score. While this situation is damaging enough, it's still technically the step that comes before defaulting on your loans.
Defaulted Loans
Default is the big Kahuna. Once your payment is 270 days late, it enters into default status. There are huge reasons why you want to avoid your student loans going into default at all costs. Here are some of the big ones:
- Credit Damage: defaulted student loans can stay on your report for a minimum of 7 years, and as a matter of fact, Perkins loans can stay on your report until they're paid off in full (!). Since 35% of what makes up your FICO Credit Score is your payment history, late payments and defaults can be a hard thing to overcome.
- Deferment and Forbearance: deferment and forbearance, two options for people who either can't pay towards their loans or simply don't want to, are not available to those with defaulted loans.
- Loan Forgiveness: that's right, student loans in default aren't eligible for the forgiveness that's a component of the income-driven payment plans offered by the federal government, or for programs like Public Service Loan Forgiveness.
- Federal Loan Eligibility: if you're not finished with your studies, unfortunately having a federal loan in default will prevent you from qualifying from any additional loans.
- Garnished Wages and Tax Adjustments: if you're super super behind on payments and haven't responded to your servicer's attempts to set up a payment, you risk having your wages garnished to pay towards your loans. Even if your wages aren't garnished, any refund you were due to get from your income tax filing could be reduced by the amount needed to get you back in good standing with your federal loan.
Long story short, having loans in default es no bueno. If you can avoid it, do so at all costs. But if you're already there, here are three ways to rectify the situation.
Loan Rehabilitation
Loan Rehabilitation is the only option we'll cover that not only allows you to restore the benefits available to federal borrowers in good standing (e.g. the ability to defer or forbear, unlimited choice of repayment program, the option to apply for a new loan), but also has a more immediate positive impact on your credit report.
To have your loan rehabilitated, you first have to agree in writing that you will, 1.) make nine voluntary, reasonable, affordable monthly payments (as determined by your loan servicer) within 20 days of your due date, and 2.) make all nine payments within a period of 10 consecutive months.
"Affordable monthly payments" is defined by your loan servicer as 15% of your household's discretionary income. If you need a reminder of how discretionary income is calculated, check out our YouTube video that breaks down the process. If the 15% payment isn't something you can afford, you can apply for a lower payment by submitting your monthly income and expenses to your loan servicer. We've included the form needed to submit your income and expenses as an attachment to this post, and if approved for a lower amount, it would count towards your required payments.
You might have reached the point where your loans are in such bad shape that your wages are being garnished to pay towards your loans. Unfortunately the loan rehabilitation payments you're required to make do NOT take your garnished wages into consideration. This wrinkle means that there is the possibility that you'll have to double on payments, which obviously wouldn't be easy to do; but if you can swing it, the credit benefits and flexibility of a rehabilitated loan are well worth it. While we covered that a rehabilitated loan has all of the privileges for a federal loan restored, it also removes the default from your credit history. The late payments will stay, unfortunately, but removing the default is a substantial benefit offered by the rehabilitation process.
Loan Consolidation
If you don't want to or are unable to complete the loan rehab process, you can instead opt to consolidate your federal student loan. By consolidating, you're essentially paying off one or more existing student loans - in this case, at least one of them being a defaulted loan - and starting from scratch with a new federal loan. If you had more than one loan that you decide to include in the consolidation, your loan servicer will use the weighted average interest rate of your old loans as the interest rate for you new loans, rounded up to the nearest eighth of a percent.
On the positive side, consolidating your loan does restore many of the benefits associated with loans in good standing. Namely, consolidated loans are eligible for deferment, forbearance, and importantly, they're eligible for loan forgiveness and additional student aid. There are some downsides however.
For one, if you choose to consolidate a defaulted loan without first making payments towards that loan, you'll be limited to choosing one of the income-driven payment plans offered by the federal government. These plans can be great, but they may not be the best solution for your household. To have your option of any repayment plan, you first have to make three voluntary, consecutive, full, on-time monthly payments towards the defaulted loan before applying to consolidate. If you do, consolidating the loan would open up all of the available repayment plans.
Secondly, consolidating a defaulted student loan doesn't take the default or the late payment off of your credit report. So while it does increase your options, it doesn't remove the negative mark that will likely bring down your score for a number of years.
Pay Off The Loan
The third option to getting out of default would be paying the loan off in full. But if you could do that, you probably wouldn't be reading this article. And also, while there are huge benefits to paying off a loan, paying it off won't remove the default from your score.
I hope I've made the case for why you want to avoid student loan default like the plague, but also how taking some steps to rehabilitate, consolidate, or pay off a defaulted loan could set you on a path of financial improvement. Student loan debt is a beast, but it's not going anywhere anytime soon (unless you really do have the cash to pay off the loan). By taking it head on and addressing it, you give yourself the best chance of it not winning the battle over your financial health.