April 29, 2023

A Closer Look at Default of Loans

Although some structural differences exist between how the Department of Education and commercial lenders administer the default process for federal student loans, the consequences for borrowers are similar. FFEL program and direct loan borrowers are in default when their payments are 270 days past due. After a borrower defaults, the servicer transfers the loan to a different entity, which is responsible for collecting the debt. This role is served by guarantors for FFEL program loans that are owned by commercial lenders; the Department of Education transfers defaulted direct loans to contracted private collection agencies. Borrowers who default are generally charged collection fees, and unlike most other types of debt, federal student loans can rarely be discharged in bankruptcy. Unless otherwise noted, this section focuses on the default process for direct loans.

Borrowers can exit default in four different ways

Rehabilitation: Borrowers can return their loans to good standing by making a series of nine on-time payments based on their incomes within 10 consecutive months. Those who cannot afford these payments can potentially make alternative monthly “reasonable and affordable” payments that take monthly expenses into account. Successfully rehabilitated loans transfer back from the debt collector to a student loan servicer and regain eligibility for income-driven repayment programs. At that point the default is resolved on the borrower’s credit history, although the delinquencies remain. Rehabilitation can typically only be used once.

Consolidation: This process allows borrowers to “pay off” their existing federal student loans by rolling them into a new loan, which they are then responsible for repaying. To consolidate a defaulted loan, eligible borrowers must either enroll in an income-driven repayment plan or make three on-time monthly payments on the defaulted loan before consolidation. Borrowers generally can consolidate loans only once, and the default remains on the borrower’s credit history.

Repayment: Borrowers may repay all or a portion of their defaulted loans. They may do this voluntarily or they may be compelled to do so. When a loan is in default, the Department of Education can initiate one or more offsets by directing the Department of the Treasury to withhold money from the borrower’s federal income tax refunds, including the refundable portion of tax credits such as the Earned Income Tax Credit; Social Security payments; and other federal programs as payment toward a defaulted student loan. Similarly, and at the same time, the entity collecting the loan can garnish up to 15 percent of the borrower’s disposable income by requiring an employer to withhold money directly from the individual’s paycheck. Like borrowers who consolidate or rehabilitate their loans to exit default, those who are subject to wage garnishment or federal offsets also may incur collection fees. Researchers have noted that differences in fees across collection methods can create confusion for borrowers and that collections can damage family financial security.

Discharge: In some circumstances, including death; disability; school closure; or certain misconduct, misrepresentation, or deception on the part of a school, the government may also release the borrower from the obligation to repay a defaulted loan.

Borrowers who default face a range of consequences

Loss of access to repayment protections and tools as well as other federal programs: While borrowers are in default, interest continues to accrue on their loans. Further, those who, before defaulting, were enrolled in an income-driven repayment plan or intending to apply for Public Service Loan Forgiveness—a federal program that discharges loans for borrowers working in the public sector after 10 years of qualifying payments—forfeit the right to make payments toward forgiveness while in default. In addition, borrowers who are in default are ineligible for additional federal student aid as well as other federal programs such as help with homeownership.

Damaged credit scores for up to seven years: Federal student loan servicers are required to report loans that are in default or more than 90 days delinquent to the major national credit bureaus. These notations remain on borrowers’ credit reports for up to seven years. Many defaulters already have low credit scores before they default: Research suggests that, on average, they experience a 50- to 90-point decrease in their credit scores before defaulting. This decline is potentially a result of delinquent payments and may indicate that those who default on their student loans are likely to be falling behind on other bills as well. Although these credit scores can recover somewhat shortly after default, borrowers with poor credit may pay more for or have difficulty obtaining credit cards, home or car loans, and other consumer credit and insurance products.

Jeopardized employment: Several states can suspend FFEL borrowers’ drivers or professional licenses if they default on a federal student loan, making it difficult or impossible for those individuals to continue working. (Some state laws limit professional license suspensions to specific industries, and enforcement of these statutes is minimal in a number of states.) In addition, service members, contractors, and federal employees with delinquent or defaulted debt can be denied security clearances, duty stations, and promotions.

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