Why strategic default is never really a good idea on a federal student loan:
Federal student loan defaults are slightly down- the latest numbers peg default rates at just over 11 percent. This is still troubling – not just because of the higher rates of default than many other financial products (almost 5 times higher than credit card defaults), but because of the vast reaches of the default consequences that are still affecting millions of borrowers.
There seems to be a consensus among industry professionals that an ongoing and multifaceted strategy will best fix the federal student loan industry, and that there is no one “silver bullet” to solve the major structural problems in the federal loan bureacracy. I’ve recently written about how some of the nations top regulators are zeroing in on these structural problems affecting federal student loan repayment, which is encouraging.
For those who are struggling to make payments to their federal loan servicer, or those who are able to make payments but are wondering about the possibility of settling, a strategic default may come to mind. This is a tactic that has been used over the years with mixed success depending on the financial product involved – with borrowers defaulting on everything from mortgages, medical bills, and credit cards in order to try to negotiate a better deal. It can be a good option for some people with private student loans, if the borrower weighs the benefits versus the negatives and there are more benefits for their particular situation. There is a large potential upside in private loan balance reduction, and we have had consistency in being able to achieve these settlements on private student loans over time. Click here for more private student loan default help.
Strategic default is not a very good idea for a federal student loan though – settlements happen inconsistently, and are very limited when they do happen. I have seen instances where after the massive default fees were applied, the federal loan guarantor only agreed to “settle” by removing the fees they just added – resulting in the equivalent of a payoff of the full pre-default balance. These default collection fees can be up to 18% of the loan amount, which is capitalized and added to the balance of the defaulted federal loan – causing the amount to skyrocket within a short period of time after default.
If you’re in federal loan default, the best thing to do is get out as soon as possible.
For those who find themselves in default, which takes 9 month to occur versus the normal 6 months on private student loans; there are options to get out and they should be explored, and ultimately acted on sooner than later. Federal loan wage garnishment, also known as “Administrative Wage Garnishment”, can be applied without having to first take a borrower to court and win a judgment – like a private creditor would have to do. Therefore “AWG” can take place quickly after default, without much time to prepare or counter it. Choosing either of the two main options to get a loan out of default are better, in my opinion, than facing the consequences of wage garnishment, tax return offset, or SSI offset. The third, and limited option of settlement certainly sounds enticing, and I get a regular amount of inquiries about it even though I am a private student loan settlement specialist. If settlement, or even a full payoff, is affordable and doesn’t negatively affect a borrowers’ other finances (for example, using a HELOC to pay off a federal student loan and then falling behind on house payments) – then it is the fastest and least expensive way to pay off a federal loan compared to any payment plan.
However, the double-edged sword of federal loan settlement is that the savings are usually small, while the default fees are quite large. If someone tried to strategically default to settle on their federal loan, they could run into an Administrative Wage Garnishement which would certainly reduce the Dept. of Ed and the federal loan guarantor’s desire to negotiate any settlement reduction. But even if that’s avoided, all that may come of the effort (which would take close to a year or more in total, including the 9 month default) may have just be a “settlement” in a reduction of collection fees only.
This would result in a payoff about the same size as the loan was before it went into default – with additional and severe credit damage. A strategic default is a serious decision with consequences for private student loans, including credit damage; but for some people the large reduction in the balance on a private student loan through negotiation is more important than preserving their credit in the short term (1-2 years). On federal loans, there’s just not a large reduction (or sometimes any reduction) on a recent default to justify going through the negative credit consequences, or risking potential federal collection actions that private lenders only wish they could use.
Settlements are rare and usually only make sense if the federal loan has been in default for a long time.
Federal student loan settlements, when they occur, are best for people that have been in default for years and have a good amount of accrued interest as part of the overall balance. Sometimes, this accrued interest can be reduced along with the collection fees. The reason why this does not work for recently defaulted federal loan borrowers is that interest is capitalized (added to the principal balance) until the loan falls behind. There’s usually not enough accrued interest immediately after default that would result in a significant percentage of overall savings on a federal loan.
Of all the hundreds of federal loan borrowers I’ve talked to, I’ve only heard someone mention settling part of the principal balance of a federal loan once. For the most part, the federal government does not want to reduce any principal and just like other lenders, they want to settle for as much of the balance plus fees as possible. So it may take 1-2 rounds of negotiation to settle a federal loan; the first round resulting in a possible reduction of fees, and the second or potential third round resulting in a possible reduction of accrued interest (if there is any significant accrued interest to reduce). In my limited experience, I found federal loan guarantors and collectors to be less open to multiple rounds of negotiation. They tend to get to their lowest acceptable offer within 1-3 rounds of negotiating, and then sticking to their final offer.
However, the federal loan guarantor may decide to be more stringent that the available Department of Education settlement guidelines – and from my experience, many of them are. Although I am a private loan negotiation specialist, I attempted to settle several federal loans earlier in my career and the best result I received was a reduction in the collection fees on the defaulted loan. The Department of Education has a very high collection rate and extraordinarily invasive collection powers, which means that they don’t have the same incentive to take a large reduction on a defaulted account the way a private student lender would.
Not sure if your loans are private or federal? Check out my informative blog article that will show you how to do just that. If you’ve been in default for years, then you may have enough accrued interest that has not been capitalized to negotiate a decent 15-20% reduction in your overall balance, by getting the federal loan guarantor to remove some of the accrued interest and the collection fee. There are some guidelines for settlement, but federal loan guarantors acting on behalf of the Department of Ed can use more stringent limits, as mentioned previously.
The National Student Loan Database (one of the main methods to view and verify student loan amounts) will show accrued interest and the principal balance separately, so if you’ve been in default for a long time, you can see how much interest has accrued. It’s also a good overall resource to be able to see all of your federal student loans in one place regardless of your situation.
If your loans are federal, you’re current or a little behind, and the thought of a strategic default has crossed your mind; my advice is: don’t. There’s just no significant upside and a high degree of variability on the limited results that are possible. The fees may well outweigh any savings, and a tax return offset or Administrative Wage Garnishment can occur before you are able to negotiate any reduction. Once an “AWG” is in place, it can only be removed through a special “hearing” process, or by making five payments on the “Rehabilitation” program. Tax offsets can be stopped via the “Rehabilitation program” or by using Direct Consolidation to get out of default.
Administrative Wage Garnishment and tax offset are without a doubt the worst ways to pay off a federal loan. Not only can up to 15% of disposable pay be garnished from a paycheck – up to 1/4th of every garnishment or tax offset payment can go towards collection fees and interest. That makes for a pretty expensive long term loan payoff if nothing is done to get out of garnishment or stop a tax offset – potentially thousands more in interest and fees paid then if the loan were brought out of default and put onto a reasonable payment plan.
If you’re having a hard time with your federal loans and are current or less than 9 months behind, it’s better to check out the different federal loan repayment plans available – often times, there is a better payment plan for struggling borrowers in terms of monthly payment amount; which can prevent a default in the future. Private student loans rarely have any different payment plans available, which is one of the key reasons why private loan borrowers default – either on accident or strategically. There are quite a few plans available for federal loan borrowers though, and switching from the Standard Plan that everyone starts on (which can be more than 1% of the loan balance monthly) to a plan related to income can be the difference between a reasonable payment period, and the life altering consquences of federal loan default.
So, the moral of the story is: federal loan settlements have a low probability of significant success, and a high probability of negative outcomes. The only time when a federal loan settlement could result in any kind of decent reduction is when it’s been in default for a long time, and a lot of interest has accrued.
Private student loan strategic defaults are a much more nuanced option. If you have a private student loan that you’re interested in settling, major reductions are often possible through negotiation. Fill out my short evaluation form here if you’d like more information on how to settle your private student loan, but make sure to keep those federal loans current.