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Student Loan Settlement Isn’t a ‘Get Out of Debt Free’ Card. Here’s What to Know

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The CARES Act federal student loan freeze has been extended to May 1, 2022, but many borrowers will still find it difficult to resume payments despite the extra time to prepare. 
18% of student loan borrowers were behind on their payments before the federal loan freeze went into effect, according to the Federal Reserve.

A survey by the Student Debt Crisis Center (SDCC) before the latest extension was announced revealed that among full-employed student loan borrowers, nearly one in five said that they would never be financially secure enough to resume payments again.

If you’re among those facing delinquency or default, it may be possible to settle your student loans for less than what you owe. However, while settlements do exist, they’re rare. And a student loan settlement may not actually be as beneficial as you’d expect. 

Here’s what you need to know about student loan settlements and what other options you have for managing your student debt

What Is a Student Loan Settlement and When Can It Happen?

In a student loan settlement, you negotiate an offer to pay your lender a lump sum of money that is lower than what you currently owe in order to fully pay off your outstanding loans along with interest, late fees, and collection charges. 

If your lender agrees, the loan is marked as satisfied once you make the payment and you no longer have to make payments toward your debt. 

While student loan settlements may sound appealing, Betsy Mayotte, president and founder of The Institute of Student Loan Advisors, cautions borrowers. “Most borrowers should expect to pay their loans in full as they agreed to when they signed the promissory note,” she says. “Essentially, the only good reason a lender might have to settle is if going through litigation might be more expensive than an actual settlement.” 

Pro Tip

A student loan settlement may not be realistic or even beneficial for your situation. Before exploring debt settlement, contact your lender to discuss alternative payment plan options to make your loans more manageable.

Adam Minsky, an attorney specializing in student loan law and contributor with the National Consumer Law Center, says that settlement can result in a favorable outcome — but only in very specific scenarios.

“Usually, only borrowers who are in default on their student loans can potentially negotiate a settlement,” Minsky says. “And default can have very significant negative consequences for the borrower, as well as any cosigner.”

Defaulting on your student loans is the first step in settling them, and doing so is a serious choice that should probably involve a debt settlement lawyer. Defaulting is considered a last resort because federal loan servicers can theoretically garnish your wages and take your tax refund to cover your nonpayment. With private loans, lenders also have the right to take you to court and sue you for your outstanding balances. At the very least, both federal and private lenders will send your account to collections and notify the credit bureaus, thus damaging your credit score.

Let’s have a look at the in-depth details of both federal and private student loan settlements.  

Federal Student Loan Settlements

Federal student loan settlements are put into two categories: standard or discretionary. The type of settlement you’re eligible for will affect your potential terms. 

The possible types of settlement are:

  • Principal + Interest: With this settlement, only your collections costs and fees are waived. 
  • Principal + 50% Interest: If you are eligible for this form of settlement, the collection costs and fees will be waived, and you’ll only have to pay 50% of the interest that has accrued. 
  • 90% (Principal + Interest): Under this settlement term, you pay 90% of the total interest and principal amount, and all collection costs and fees are waived. 
  • Discretionary: If you can’t afford the other settlement options due to extraordinary financial issues, you may qualify for a discretionary settlement. However, your loan servicer will have to submit the discretionary settlement proposal to the Department of Education for its approval. 

For example, let’s say you currently owe $5,000 in principal, $2,000 in interest, and $1,000 in collection costs and fees, for a total of $8,000. Here is what you would pay under each standard settlement type: 

Principal + InterestPrincipal + 50% Interest90% Principal + Interest
$7,000$6,000$6,300

Private Student Loan Settlements

Private loans are issued by banks and online lenders instead of the government, so they don’t have as standardized regulations as federal loans. 

“Federal student loan settlements are governed by federal guidelines and regulations, which place limits and constraints on those settlements,” says Minsky. “Private student loans generally have more flexibility, but this can vary significantly depending on the specific lender involved.” 

How settlements are handled and how much you can settle for is entirely dependent on your lender. 

“There is no typical percentage amount, as student loan settlements can vary wildly depending on the type of student loan, the lender, the borrower’s mitigating factors, and whether the borrower has any viable legal defenses or disputes,” says Minsky.

How to Negotiate Student Loans

To start the student loan settlement process, you can negotiate with your lender on your own, or you can work with a debt counselor or attorney to negotiate on your behalf. 

“Borrowers should consult an attorney specializing in student loans in cases of bankruptcy or significant disputes or if there’s a chance the loan might be beyond the statute of limitations for collection,” says Mayotte. 

After consulting with a lawyer, debt counselor or tax professional, you can start the settlement process by following these steps: 

  1. Gather Proof: When you contact the lender or loan servicer, they will usually ask for proof that you cannot reasonably repay the amount owed. You will have to submit documentation of financial hardships, such as current pay stubs, recent tax returns, or proof of ongoing expenses like medical or childcare costs.
  2. Save Up Money: To settle your debt, you have to pay a lump sum of cash. The amount required can be substantial; for example, federal loans may only waive the collection costs, and you’ll have to pay the full amount of the principal and interest. 
  3. Review Typical Settlement Procedures: Before entering into negotiations, it’s a good idea to research what kind of settlement you can expect. For example, federal loans have very specific guidelines for acceptable settlements, so you want to be sure you’re comfortable with those terms before talking with your lender. “Every case is different,” says Mayotte. “For private loans, some borrowers have been successful paying 50 cents on the dollar or less.”
  4. Contact the Loan Holder: Contact your loan holder. In some cases, that may be your lender or loan servicer. If you entered into default, your account may have been sold to a collection agency, so you’ll have to negotiate with the agency instead. Explain your circumstances, and offer to settle the loan with a lump sum payment. 
  5. Get the Agreement in Writing: If your loan holder agrees to the student loan payoff proposal, make sure you get an agreement outlining the terms in writing. Once you make the payment to settle the loans, get written confirmation the loan is paid, and you’re no longer obligated to make payments. 

Potential Drawbacks of Student Loan Settlement

Settling your student loans for less than what you owe can sound great, but there are some significant drawbacks to consider. 

Your Credit Will Be Impacted

To settle student loans, you usually have to already be in default. For federal loans, that means you’re 270 days or more behind on your payments. For private loans, it typically means being at least 120 days behind, although the exact time period may vary by lender. Missing so many payments can significantly damage your credit score, making other creditors wary of working with you. 

If you successfully settle the loans, the default will be removed from your credit report. However, the account will show up as a settled debt. Settled accounts note that you didn’t pay the full amount, and they’ll stay on your credit report for seven years. Having a settlement on your credit report could make it difficult to qualify for other forms of credit. 

You May Have to Pay Taxes

If you settle your debt, you may owe taxes on the discharged amount since the IRS views the waived portion as income. If the discharged amount is more than $600, the loan holder will send you a 1099 form, and you’ll have to report it on your tax return and pay taxes. 

There’s No Guarantee the Lender Will Agree

Although you can make a compelling argument to your loan holder, there is no guarantee that they will agree to your settlement proposal. 

“Keep in mind that the borrower is legally bound by the promissory note they signed and a lender is under no obligation to accept a settlement and can instead choose to litigate to collect,” says Mayotte.

Federal loans may be harder to settle than private loans, since the government can garnish the borrower’s wages without a court order. Private lenders typically have fewer tools available to collect on the debt, commonly relying on lawsuits instead.

Alternatives to Student Loan Settlement

Student loans settlement shouldn’t be the first course of action. If you’re struggling to make payments, there are other ways to make your loans more manageable. 

“Before going into default, try to find ways to repay and work with your creditor,” says Leslie Tayne, a student loan expert and founder of Tayne Law Group. “Remember that defaulting on a student loan will damage your credit. However, resolving it can help improve your credit if done correctly.”

Student Loan Rehabilitation

Federal loan borrowers that have defaulted on their loans may be eligible for student loan rehabilitation. It’s a process where you work out a payment amount with your lender and make nine payments on time within ten months. 

“Before you negotiate a settlement, try to rehabilitate your federal student loan to get it out of default,” says Tayne. “If you’re able to do it, the default will get removed from your credit report, which will bring up your credit score. You can also apply for an income-driven repayment plan to get more manageable monthly payments.”

Income-Driven Repayment Plans

If you haven’t defaulted on your federal loans yet but are struggling to afford your payments, you can apply for an income-driven repayment plan. If approved, your repayment term will be extended and your monthly payment will be calculated based on a set percentage of your discretionary income. 

Alternative Payment Options

Private loans don’t have the same benefits or processes as federal loans, but you may be able to get help if you reach out to your lender. 

“If you have private student loans, contact your servicer to see what assistance they can offer,” says Tayne. 

Some lenders have alternative payment plans or their own rehabilitation processes for borrowers experiencing financial hardships, so there may be ways to get back on track that don’t involve student loan settlements. 

Debt Counseling

If you need help negotiating with your lender or coming up with a plan to repay your debt, contact a non-profit credit counseling agency for free or low-cost assistance. A debt counselor will review your situation and work with you to develop a plan to repay your loans.