A New Hope for Student Loan Defaulters

A change to the federal student loan program this month presents a huge opportunity to borrowers who have defaulted on their loans from the government. Loan rehabilitation allows borrowers to return to current repayment status, access the benefits offered to borrowers in good standing and have the default removed from their credit history. With changes that went into effect July 1, that process became much more accessible to struggling borrowers.

What Is Student Loan Rehabilitation?

A federal student loan borrower fails to make a payment for 270 days, the loan goes into default, which triggers a wave of consequences that include losing your eligibility for federal student aid; losing eligibility for deferment, forbearance and repayment plans; having your loan sent to a collections agency; wage garnishment; and several other unenjoyable things.

Your credit standing will take a severe hit, which will take years to correct, and you only have three options for getting out of default: repay the loan, consolidate the loan or enter loan rehabilitation.

To rehabilitate a Direct loan or FFEL Program loan, you must make nine of 10 payments deemed “reasonable and affordable” by you, the Department of Education and the debt collector. (For a Perkins loan, you need to make nine of these payments in a row.) Once you’ve done that, a lot of good things happen: You once again have access programs like student loan deferment and income based repayment (IBR), and the default status is removed from your credit history (though delinquencies predating the default will remain) — that’s huge for your credit standing. You’re also not going to have to deal with wage garnishment anymore.

You need to be very careful, though: Outstanding collection fees (18.5% of the loan balance) will be added to your principal, meaning your loan payments could be much higher than they were when you defaulted, so it’s up to you to set up an affordable payment plan. Rehab is a one-shot deal, so if you default again, the option is no longer available to you.

What the Changes Mean for Borrowers

In its previous state, the rehab program had some hangups. The biggest issue had to do with the debt collectors trying to recover the defaulted loans.

“Debt collectors demanded a payment based on a commission payment, and they only took a commission if they took a payment of 1% or more of the loan,” said Joshua R.I. Cohen, a Connecticut attorney who calls himself “The Student Loan Laywer.” For example, if you had a $50,000 loan, the collector would demand a $500 payment for rehabilitation (on top of any involuntary wage garnishment), even if that amount exceeded 15% of the borrower’s discretionary income, which determines income-based repayment. Rehab was, in a word, unaffordable. For five years, Cohen has been filing lawsuits against collectors for not offering affordable payments.

Debt collectors were also not obligated to discuss loan consolidation with debtors, so rehab seemed like borrowers’ only option.

Now, borrowers should know they can use the income-based repayment benchmark to determine their “reasonable and affordable payment.” If the amount a defaulted borrower is supposed to pay on a 15% income-based repayment schedule is still unaffordable, the borrower can negotiate a lower payment. After five on-time payments, borrowers can ask to have their wage garnishment suspended (making it easier to continue the rehabilitation), and if they successfully complete their nine rehabilitation payments, the wage garnishment will be permanently removed.

“With this it becomes much more reasonable to switch from being in default with wage garnishments to having a more normal status,” said Mark Kantrowitz, Senior Vice President & Publisher of Edvisors.com. “That ultimately will benefit the lender, because oftentimes being in default on the loan causes all kinds of financial difficulties for the borrower that make it harder for them to pay.”

Having a default on your credit report will hurt your credit scores, and having poor credit makes other loans more expensive by way of higher interest rates. That in turn leaves the borrower less money to put toward the defaulted loan.

How to Get Out of Default

Consolidation is a faster way out of default than rehabilitation, but it doesn’t benefit your credit standing like rehab does. The added collection fees certainly aren’t a positive aspect of rehabilitation, but it may be worth the advantages.

Figure out what your monthly income-based repayment amount would be (there are calculators online to help with that), then contact the collector to start the process. If you successfully rehabilitate your loan, you’ll want to apply for income-based repayment so you don’t end up in the same predicament that landed you in default in the first place: unaffordable monthly payments. With IBR, any unpaid balance after 25 years of repayment will be forgiven.

It’s not like this is the panacea to the nation’s problem with student loan debt. Many still consider the system broken.

“The fact that I exist, I run a law firm that right now only deals with student loans, that tells you there’s a problem with the industry,” Cohen said.

Mitch Weiss, a finance professor at the University of Hartford and a Credit.com contributor, pointed out that these relief programs shouldn’t only be available to borrowers as far off the rails as those in default.

“If you have a borrower who has missed two or three payments, it’s unlikely you’re going to get that back to be current,” Weiss said. Default, 270 days past due, amounts to nine missed payments, meaning the borrower has probably long-passed the point of catching up, but fees and interest continue to add up before that borrower hits default. “There is something fundamentally wrong with the loan servicing process that borrowers are allowed to become so delinquent. The remediation programs that exist should not be exclusive to those that are so severely past due.”

Despite his issues with loan rehabilitation, Weiss said it’s “an OK option” for struggling borrowers. Consumers who have defaulted on their student loans should take the opportunity seriously, because getting the default off their credit report can make a huge difference in other areas of their finances. You only have one shot at it, though, so make sure you make a plan to afford your loan payments once you’ve emerged from default.

If you’re concerned about how your student loan payment history is affecting your credit, it’s a good idea to check your credit reports regularly to make sure they’re accurate, and to monitor your credit scores. This way you can get a clear picture of your credit situation, and begin to put together a plan to get your credit back on track. You can get your credit reports for free once a year through AnnualCreditReport.com, and you can use free tools through Credit.com to check two of your credit scores every month, and get an overview of what’s affecting them.