Student Loan Debt Settlement and Its Effect on Your Credit
Student Loan Debt Settlement: Student loan debt can feel like a big burden and millions of Americans have already defaulted on their obligations. Borrowers may have the option of erasing their debt burden through student loan settlement. When a borrower settles a student loan debt, they agree to pay less than what they originally owed.
A debt settlement is an agreement a lender makes with a borrower to accept less than what was originally owed as full payment. It is different from loan forgiveness and discharge, which cancels the balance only under special circumstances.
On this page:
Types That Can Be Settled
How student debt settlement works
Consequences of Student Debt Settlement
Alternatives to Student Debt Settlement?
What Types of Student Loans Can Be Settled?
Federal student loans can be settled but the borrower has to be in default. Even though settling federal student loans is an option, it is really rare. With federal loans, the government will often prefer other options to collecting the debt, such as wages/tax refunds or rehabilitation.
Settling student loan debt is even more common with private student loans. This is because private lenders have fewer options of getting money from borrowers when they default.
With federal student loans, the government can initiate wage refunds while private lenders must first go to court.
How Student Loan Debt Settlement Works
Your options are different for federal and private student loans, but debt settlement follows a similar three-step pattern 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. When your federal loan is in default and you have not 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, take your driver’s license and more– without even going through court first.
Moving your loan to a collection agency usually incurs charges, which are added to the amount you owe. Contact your loan servicer to ask about your options.
Negotiate the debt settlement. Negotiation is essential in the debt settlement process. Borrowers can hire a lawyer, enter a plan with a debt settlement company or even negotiate a settlement independently.
Consulting a student loan lawyer can be helpful if you are struggling with repayment, already in default, or if you want to know more about your options. When a borrower is trying to settle student loan debt, a lawyer can help with the negotiations and if the settlement outcome is favorable to the borrower, the cost of the lawyer’s services may be worth it.
Borrowers without a lawyer should get the settlement agreement and terms in writing. They should also make sure they receive a statement showing when the debt has been paid in full based on the settlement terms.
Pay the agreed-upon amount. Get the settlement deal in writing, along with a receipt when you have paid. And keep copies of both in case you need to prove that the loan is paid in full.
Settling student loan debt can be a huge financial relieve, but you may need to deal with the consequences such as damage to your credit score and tax implications. Here’s what you need to know about what happens even after the settlement.
It will affect your credit score. Whether private or federal, a student loan may negatively affect your credit score while it is default and once it has been settled.
Default 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 once they’re late. Borrowers who are late on their payments see their scores drop by an average of 50 to 90 points before they finally reach loan default. A damaged credit history may affect your ability to get a mortgage, pass an employment credit check an more.
Once you settle the student loan debt, the account will again 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 defaulted.
You’ll owe taxes. Any debt that was canceled in the settlement is generally considered as taxable income, according to the IRS. If your loan balance was reduced from $60,000 to $40,000, then you will owe taxes on the $20,000 that was canceled.
Alternatives to Student Loan Settlement
You should consider some of these alternatives to student loan debt settlement:
Income-driven repayment plans. Federal student loan borrowers can enter repayment plans that will set their monthly payment as a percentage of income. That is as long as the loan is not in default. If your income is low enough, your payment can be zero dollars.
Deferment or forbearance. These options are available for federal student loans and may be offered through a private student lender. They allow borrowers to reduce or stop loan payments temporarily . Depending on the type of loan, you may not have to pay interest accrued when a loan is in deferment. But typically, you will have to pay accrued interest when a loan is in forbearance.
Student loan forgiveness. Federal student loan borrowers may be eligible and up for student loan forgiveness programs. These programs may be available based on your profession, state or employer.
Private lender hardship options. You should 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 sort out what you can pay and offer tips for communicating with your lender.
Refinancing. Generally, refinancing federal student loans into new private student loans is not a nice idea, but you might be able to make payments on private student loans more affordable for you with refinancing. If you can qualify for an offer with a lower interest rate than your current loans, refinancing can help you with reducing your monthly payments.
Even though debt settlement is possible for private and federal student loans, your credit score may be damaged in the process, and you may owe taxes on the forgiven debt. Other options like establishing a loan rehabilitation agreement, entering an income-based payment plan and discussing hardship programs with your private lender, may serve as good alternatives to avoid default or debt settlement.