Is Strategic Private Student Loan Default For Debt Settlement A Good Strategy?

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Out of all the questions I get from borrowers, “Is pursuing strategic default for private student loan debt settlement a good strategy?” is one of the most common. A strategic default is when a borrower intentionally stops making payments in order for the account to default. No counselor or company should ever tell someone to default. It should be a decision the borrower makes on their own after considering the pros and cons, and weighing the outcome against their current situation.

When Is Strategic Default for Private Student Loans Likely An Option?

When private loans barely go down after paying huge monthly payments over several years, or in the worst cases when the balance does not go down at all or even increases; strategic default starts to enter the thinking of even those borrowers who have never missed a payment on anything in their lives. Ideally, only borrowers who will inevitably be late on payments should consider strategic default for private student loans; but the lack of payment options and high interest rates have made strategic default something that private borrowers are considering regardless of their ability to pay their next monthly payment.

Update: 7/2017

Navient borrowers – we have seen a troubling trend with Navient accounts this year, where Navient attempts to reach out to family members, friends, places of employment, or even neighbors to try to reach the borrower when their loans are delinquent. This type of “skip tracing” is a tactic more commonly associated with third party debt collectors, and can be more difficult to stop when it’s done by an actual lender such as Navient. We have been able to get calls for borrowers stopped in the state of California, due to their consumer protection provisions that include original creditors. In most other states, it will be difficult to get these calls to stop, but one way you can try is by filing a CFPB complaint. When borrowers have informed me of these calls, in every case so far Navient did not disclose details of the debt to the person they called.

In most cases, settlement is only available for private student loans in default or severely delinquent student loans (private). When borrowers do the math and see that they will be paying tens of thousands of dollars in interest over decades before their student loan is paid off, it can make strategic default seem like a faster, less expensive way to pay off a private loan. 

While this can be true, there are also some caveats. Strategically defaulting on a private loan is an aggressive, adversarial process that involves trade-offs and taking on a significant amount of risk. However, the risks can be mitigated, and when done properly negotiation can lead to a reduced sum settlement of 50% of the balance or less.

Here are the main issues to consider when deciding to strategically default:

Credit Damage

Credit damage is one of the biggest concerns for borrowers who are intentionally going late on payments. This cannot be understated – the credit damage will be major and it will take 1-2 years post settlement to rebuild into a good score range. We’re talking a 150 point drop, or even more. If you decide to strategically default, it’s a good idea to make any credit based lending decisions prior to missing the first payment – such as applying for a mortgage, refinance, or auto loan.

While on some old credit card accounts it can be possible to negotiate a “Pay for Delete” or to otherwise negotiate credit reporting terms along with a settlement, this has not been the case with student loans which are private – the credit reporting is generally non-negotiable as far as the lender is concerned. A reputable credit repair company may be able to remove a paid charge-off and old delinquent marks after a settlement has occurred, but this is not something the lender will agree to as part of the settlement.

The lender must accurately report the settlement per FCRA guidelines as “Paid for less than the full balance” or “Settled for less than the full balance”. This will actually report much more positively than a charge-off. The issue is the credit damage that is accumulated on the way to the default, not the notation from the settlement itself. In fact, by the time the accounts are defaulted the credit damage is done for the most part, and the settlement notation will begin the process of rebuilding credit.

I like to say to borrowers who are considering strategic default that they have to think of it as sacrificing their credit score. Not taking a hit, or dropping down a few points; but sacrificing the score entirely for up to a year or more after the settlement takes place. With credit building tactics such as using secured credit cards and keeping utilization under 30%, it can be possible to build a credit score back up to a good range from 1-2 years after the settlement – a process that begins with the settlement itself. Another positive effect of settlement on overall credit scoring is an improved Debt to Income and Debt to Credit ratio.

Borrowers accumulate credit damage during a strategic default from the monthly delinquency marks that hit their credit report. The last mark at 180 days (210-240 days for Navient) is the charge-off, which is when the account officially defaults. The credit damage should plateau at this point, and the credit score will usually increase after the settlement is paid. For some of my clients who had a charged off private loan for several years, they actually noted a 100 point increase in their scores after the settlement was paid (compared to their score when the account was charged off). Another recent client experienced a 150 point rebound in just 6 months after settlement (from 600-750) although in my experience it usually takes a little longer. 

One factor of critical importance is that any co-signers will experience the same late hits as the borrower. This is not to say the numeric impact will be the same, because the cosigner may have a different credit profile. But they will experience the same late hits leading up to and including the default, and overall it will have a very negative impact regardless of what other positive credit attributes make up their credit profile. The bottom line is – if you’re considering intentional default, say goodbye to your credit for the time being. However, after settlement, you can rebuild into a good score range after about 6 months to 2 years; and you’ll have an improved overall credit profile due to the private loan amount no longer being calculated in Debt To Income or Debt To Credit ratios. 

Settlement Savings

So, why would anyone consider defaulting with such a massive and long lasting impact to their credit score? It comes down to the dollars and cents that can be saved through settlement negotiations. Private lenders write off hundreds of millions of dollars every year – they fully expect some of the loans they originate to not be paid in full (or at all). This opens the door for settlement. Settlements on private loans can vary, although the operative range for most private loans is 40-60% of the balance. This number may be lower for accounts that have not been paid in several years, but intentionally defaulting and then waiting for several years to settle is not the best idea because of the increased risk of litigation as well as the continued accrual of late fees and interest. Borrowers who have defaulted and made it several years without being sued have basically won a coin toss as far as settlement possibility, but I don’t advocate any strategy that has only a 50% chance of success. It’s much better to settle for a significant reduction early on in the default period, which minimizes exposure to litigation and accumulated interest. 

For most recently defaulted accounts, a 40-60% settlement is the norm – but don’t expect the lenders to easily agree to this. Many debt collectors and private loan lenders hardball borrowers because they know that they have an information advantage compared to someone who is attempting to settle on their own for the first time. A lack of experience with a particular lenders’ collection cycle can be a big impediment to anyone trying to settle their loan, which is why it can make sense to hire a professional, performance based negotiator. Besides getting stonewalled in negotiations, there are many other pitfalls to avoid while negotiating private student loan settlement and also while executing the negotiated settlement, once an agreement is reached. One of the main mistakes I hear about from borrowers who attempted to negotiate on their own was mentioning assets, income, and even providing tax returns. These are all a no-no when negotiating, but it’s an understandable mistake since collectors will press borrowers hard for this information when they get them on the phone. 

Another big mistake borrowers make is presenting the first offer for the amount they actually want to settle at. It seems sensible, but that is not how negotiating settlements works. You want to open up the negotiations at far lower than the amount you want to settle for. At the same time, you don’t want to insult the lender, so you want to make the first offer lower than your intended settlement, while putting a big enough chunk of change on the table to get the lender or collector interested.

If these pitfalls are successfully avoided, and a viable settlement strategy is properly executed, the settlement savings can be massive – not just compared to the current balance, but to what the alternative of paying interest plus principle for decades would have cost. Some lenders even offer structured settlement terms, where the borrower pays a down payment on a fixed settlement amount, with the remainder paid in monthly instalments over 12 months or longer. This can make settlement more affordable. Done right, settlement negotiations can be the fastest and least expensive way to pay off a student loan – especially considering the lack of available payment options and exorbitant interest rates.

As a disclaimer for those who are wondering if this strategy is applicable to federal loans – in my opinion it is not. Federal loans rarely settle for much of a reduction, and huge fees equal to 1/5th of the balance are capitalized at the time of default, which offsets any potential limited settlement savings. Strategic default can be a viable option for student loans from private lenders, but not for federal student loans. Luckily, federal student loans have a variety of flexible repayment plans available. 

Accumulated Interest and Fees

During a strategic default, the balance is going to grow compared to what it was prior to missing your first payment. This is usually 5-10% of the balance before you missed a payment, but it can be more. For most of my clients, it’s usually about 5% of the balance in accrued interest and fees from the first missed payment, to the default. This is one of the reasons I encourage borrowers to settle shortly after they’ve defaulted, if possible. Usually, the settlement savings are going to more than offset any fees and interest that accumulate during the strategic default.

Potential Legal Action

Strategically defaulting on a student loan from a private lender, especially a large balance, opens the door to the possibility of litigation if no settlement or payment plan is agreed to during the initial phase of collections post-default. While lenders love to throw around the vague threat of legal action, it’s usually a last resort for them. A lender can only take you to court if a collection attorney who is licensed in your state (or your cosigner’s state) receives the accounts to collect on for that lender, and they have to send you a letter first with several disclosures mandated by the FDCPA. So if you see a collection attorney letter and they have an attorney licensed in your state, it’s time to take action. Keep in mind that many collection attorneys collect on accounts in states where they are not licensed to sue, since just the name of an attorney on a debt collection letter is enough to get people to pay up. Negotiating a settlement when an account goes to a collection attorney that is licensed in your state can be more difficult, especially for borrowers attempting it on their own for the first time, but it is still possible in many cases – they still would rather settle or take a payment plan than going through the costly litigation process, with no guarantee that they can collect even if they do get a judgment. The last settlement I negotiated with a “same state attorney” firm resulted in a settlement of 40% of the balance structured over several years.

However, if communication is ignored when the accounts are placed with a “same state attorney” and no settlement or payment attempts are made, litigation can be the end result. If you are summoned to court by a collection attorney, it’s best to hire a lawyer with experience dealing with consumer debt defense. Non-attorney debt negotiators cannot give you legal advice, and most cannot negotiate effectively during the time period between when you’ve been summoned to court and when you’ve received a judgment. In many instances, consumer defense attorneys can still negotiate a reduced sum settlement during the litigation process however. 

During the strategic default process, some people can laugh off the collection calls and send them all to voicemail for their negotiator to call back. Others literally lay awake at night with fear of “doomsday outcomes” such as losing their house, being forced to sell their personal assets, etc. These types of collection actions almost never happen, and in many states there are laws preventing that type of collection activity. Wage garnishment or bank account levy can only occur with private loans after a collection attorney has won a judgment against a borrower and then gone through the process of executing that judgment. Even if someone does not respond to a lawsuit or hire an attorney, and receives a default judgment; there is still the opportunity to settle the judgment and avoid wage garnishment, bank account levy, or property liens. 

Having a logical gameplan and realizing that there are many opportunities to settle or work out a payment plan prior to legal action is the key to defeating this type of fear based reactive thinking. However, if you’re the type of person who will worry about losing your house after getting a call from a cubicle warrior collection agent, then the adversarial process of debt negotiation may not be for you. Hiring a professional can help you sort fact from fiction when it comes to collection threats; and in many cases debt collectors will treat a professional negotiator much differently than they would treat the borrower. In this way, working with a professional negotiator with experience settling student loans from private lenders evens the playing field, and increases your chances of securing a huge settlement reduction. By hiring a good negotiator early on in the collection cycle, you’ll be able to work out a settlement long before legal action is being considered by the lender. 

Weighing the Pros and Cons

A strategic default is a very serious financial decision that should not be taken lightly. It is an adversarial process, and not for those who are easily rattled by the typical empty debt collector threats. Expect to get tons of phone calls and letters, which occasionally include calls and collection letters sent to your place of employment (if you didn’t provide this info to the lender, they may be able to still find it from a Linkedin Profile). Third party collection calls can be stopped, and these are often the most harassing. However, it is much more difficult to stop collection calls when the account is still being collected on by the original lender, and usually you just have to ride these calls out. Having a debt negotiator on your side can also minimize collection calls, since they will establish themselves as the main point of contact with your lender and your lender will get used to talking with them, if they are unable to reach you.

Once you look past all the surface level noise and “last chance” collection letters, there is the very real possibility of settling a private loan for half of the balance – or even less. The question you have to ask yourself is – am I willing to sacrifice my credit score and deal with very unhappy debt collectors calling me for months in order to get to the point of negotiating a settlement on my own, or with a professional negotiator?

No ethical professional can tell you whether or not you should pursue a private student loan default for a debt settlement – it is a decision that must be made on your own after considering the positives and negatives, and after comparing a potential settlement to your current payment arrangements with your private lender.

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About Andrew Weber, NACCC Certified Student Loan Counselor

Andrew Weber is a NACCC Certified Credit Counselor and a NACCC Certified Student Loan Counselor. He is the only certified student loan Counselor who specializes exclusively on private student loan issues in the US. He's helped hundreds of borrowers drastically reduce their debts.

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