No one sets out to fall behind on their student loans. But default comes with serious consequences, including wage garnishment, tax refund and Social Security benefit seizure, and damage to your credit report that could last for seven years.
You may have heard of bill or credit card debt settlement, but is it possible to settle your student loans? The short answer is yes. But negotiating a settlement can be difficult. To increase the odds of a positive outcome, it’s best to learn everything you can about this arduous process.
What Is Student Loan Settlement?
Student loan settlement works just like debt settlement. If you’re in default and it’s unlikely you’ll ever be able to pay off the debt, the lender agrees to take a smaller amount than you owe just to ensure they get some of the debt repaid.
Once you’ve completed the terms of the settlement, you’re done. The lender discharges your debt, meaning it removes the default and delinquent status from your credit report, which will show a $0 balance. And it can’t come back and ask for the rest of the money later.
Usually, you must pay the agreed-upon amount in one lump sum. Occasionally, the lender allows you to make monthly payments. The primary difference between settling regular debt and student loans is that you may have less ability to negotiate federal loans than private ones.
Can I Settle My Student Loans?
Student loans are unlike other forms of consumer debt. Thus, settling them is more complicated.
And it’s far easier to settle private student loan debt because federal student loans are technically debt you owe to American taxpayers, and Congress sets the settlement rules.
But that doesn’t mean private student loans are easy to settle. You have less bargaining power than with other forms of consumer debt since it’s more difficult to discharge student loans in bankruptcy.
Thus, a private lender could force you to pay up, whether by garnishing your wages or bank accounts or seizing or making a claim on your property. Note that a private lender can never collect on government money, such as tax refunds, government pensions, or Social Security.
But the United States Department of Education (ED) can garnish your wages or seize your tax refunds or Social Security without first getting a court order. Thus, if you default on a federal loan, the U.S. government has extraordinary powers to collect and little incentive to settle.
However, while settling your student loans is difficult, it’s not impossible.
To even begin to settle, your loans must be in default. Federal loans enter default after 270 days (nine months) of missed payments. And private loans typically enter default after 90 days (three months) of missed payments, though it varies by lender.
It’s not possible to settle student loans that are in good standing. That’s because companies who handle student loans won’t entertain the option of settling a loan for less than you owe when there’s any possibility of collecting the full amount.
Thus, you have to demonstrate you can’t repay the loan by allowing it to default. Typically, that means letting it get sent to a collection agency.
But even then, student loan lenders aren’t always open to settlement offers. For a private lender to be willing to negotiate, you must demonstrate it’s more worthwhile to settle with you than drag you to court. Typically, that means proving financial hardship.
To settle a federal student loan, you must be able to pay off most of your loan balance in a single lump sum.
Settling Federal Student Loans
Federal student loan settlements are difficult to get, but they are possible. Federal law allows you to settle direct loans for less than the full amount. Direct loans include subsidized and unsubsidized loans for both undergraduates and graduates and grad PLUS and parent PLUS loans, FFEL (Federal Family Education Loan Program) loans, and Perkins loans.
However, federal guidelines severely limit how much of a balance reduction you can get through a settlement. And you’ll have to pay the settlement in a lump sum.
But if you’re in default and have access to a lump sum large enough to pay off your debt, it could be worthwhile to investigate the possibility. That’s especially the case if you’re facing garnishment or other consequences due to the default.
When You Can Settle Federal Student Loans
Federal student loan settlements are rare because the ED has ways to collect on defaulted loans, including wage garnishment and tax refund or Social Security benefit seizure. And unlike private lenders, they can collect without suing you first.
A bipartisan bill was introduced in Congress in August 2021 to make it easier to discharge student loans in bankruptcy, but it has yet to pass. And since it’s extraordinarily difficult to discharge student loans in bankruptcy, there’s little threat the ED won’t be able to collect.
Thus, the ED has little incentive to settle student loans. However, it may make an exception in the following situations:
- You’ve Defaulted More Than Once on the Loan. Rehabilitation removes the default from your credit history and lets you make payments based on your income. But you can only do it once. If you default again, the ED will be more willing to settle.
- You Can’t Afford to Repay the Loan. If you’ve defaulted on the loan, the balance becomes due in full. If you can’t afford to pay it, the ED may be willing to negotiate a settlement. If not, you’ll face legal action.
- You Have a Lump Sum to Settle the Debt. Although you’re unable to afford to repay the loan in full, to settle with the ED, you must still have a lump sum in the amount of the settlement offer. So if you don’t have it yourself, you’ll have to borrow it from someone.
- The ED Can’t Collect the Debt. The ED may accept a settlement if it can’t collect from you any other way. That’s rare because it can collect on federal money, including tax refunds, Social Security benefits, and government paychecks or pensions. But that’s sometimes impossible, such as when you’ve moved out of the country.
Federal Student Loan Settlement Options
Because Congress dictates the rules governing federal student loan settlements, you can’t negotiate with federal loan collectors the way you can with private lenders. Federal student loan collection agencies are companies that negotiate on behalf of the ED and must follow the prescribed rules.
Collection agencies are only authorized to offer you certain deals, referred to as “standard compromises,” none of which will save you much money.
Specifically, the ED can settle FFEL or Perkins loans of any amount. They can also suspend or terminate collection of these loans.
Additionally, they can offer any of the following standard compromises for settling direct loans:
- Waiver of Fees. The ED forgives all debt collection and late payment fees. The borrower is responsible for paying 100% of the principal and interest.
- Waiver of Fees and 50% of Interest. The ED forgives all fees plus 50% of the interest on the loan. The borrower is responsible for paying the remaining interest plus 100% of the principal.
- Waiver of 10% of the Principal and Interest. The ED forgives 10% of the combined interest and principal balance. The borrower is responsible for paying the remaining 90% of the total balance.
For anything else — what’s referred to as a “discretionary compromise” — the ED must grant express written permission. Specifically, you must write a letter detailing why the ED should accept your offer for less than the standard compromise. For example, you have cancer, are older, or are facing financial hardship.
The ED provides no insight into what they’ll accept for a discretionary compromise. However, Stanley Tate, a well-known student loan lawyer, notes that in his experience, federal student loans seldom settle for less than 85% of the outstanding balance.
Whatever settlement you agree to, you must pay the negotiated amount as a lump sum within 90 days.
Settling Private Student Loans
Although it’s still trickier than with other forms of consumer debt, if you’re trying to settle private student loans, it’s far easier than it is with federal student loans.
Unlike the ED’s collection agencies, the private companies who own these loans can establish their own criteria for debt settlement.
Private companies also face obstacles federal loan collectors don’t.
Private lenders can collect on the debt by garnishing your wages, seizing cash from your bank accounts or investment funds, or placing a lien on your property. A lien prevents you from selling property, such as a car or house, without paying off the debt with any profit. They can also seize the property itself, though that’s rarer.
But unlike the ED, they have to get a court order, which means suing you first. And that may not be worth it, depending on how much you owe.
Private lenders also can’t touch federal money. That means they can’t garnish your tax refunds, Social Security benefits, or other federal payments (such as a federal pension or paycheck from a federal job).
All this means private lenders are more willing to work with you if it could mean getting nothing at all.
That said, there are no guarantees. No private lender is required to settle, and some may not, even if the loan is in default.
One silver lining is that a New York-based federal court of appeals ruled in July 2021 that private student loans are dischargeable in bankruptcy. But that doesn’t necessarily mean other courts will agree.
Until it becomes a matter of law, discharging private student loans in bankruptcy may not prove any easier than discharging federal student loans, depending on where you live and how favorably the judge looks on your case.
Ultimately, with bankruptcy up in the air, you don’t have as much bargaining power to settle the debt as you would with other consumer debts.
When You Can Settle Private Student Loans
Settlements for defaulted private student loans are far more common than federal student loan settlements because private lenders don’t have the collection leverage of the ED. Thus, a private student loan lender may accept a settlement in the following circumstances:
- The Loan Is in Collections. Although it varies by lender, private student loans typically default after 90 to 180 days (three to six months). Once an unpaid debt is old enough (usually six months), the lender sends it to a collection agency, which attempts to collect whatever they can on the debt. Thus, it’s likelier you can settle the loan for less.
- You Have Little Income or Few Assets. The lender or collection agency will decide based on its perception of your ability to repay. If it doesn’t think it can collect more than you’re offering, then it’s more likely to accept a settlement.
- You Have a Lump Sum to Settle the Debt. Unlike the ED, many lenders allow you to pay off the settlement in installments. But you’ll always get a better deal with a lump-sum offer.
- You Have a Strong Legal Defense. If you can prove there’s a legal reason they may be unsuccessful in their lawsuit, you could motivate them to settle or even dismiss the debt. For example, they may have violated the Fair Debt Collection Practices Act.
- The Statute of Limitations Has Expired. The rules vary by state, but after a certain number of years (usually three to 10), your lender can no longer sue you. Thus, your chances of a settlement are higher. But don’t attempt to run out the clock intentionally. Litigation could pop up before the statute expires or you could unwittingly restart the clock, depending on state laws, which can be complicated.
Private Student Loan Settlement Options
Every private lender has its own policies on settlements. Settling for less than the amount owed is very low on the list of desired outcomes for the lender.
Yet according to Tate, the student loan lawyer, many lenders are willing to settle for 40% to 75% of the amount owed. That’s especially the case if it seems that’s the most they’ll be able to collect from you, even if they were able to sue you successfully.
Typically, there are three types of private student loan settlement options:
- Lump-Sum Settlement. You make one large payment to settle your student loan for less than the balance owed. Usually, you get the biggest discount if you’re able to make a lump-sum settlement.
- Monthly Payments. You agree to make monthly payments up to an agreed-upon amount over several months or years. If you miss a payment, the offer is void, and you’ll owe the full balance.
- Lump Sum Plus Monthly Payment. You make an initial lump-sum payment followed by smaller monthly payments until the agreed-upon amount is paid in full.
Can You Settle Your Student Loans?
If you’re in default on your student loans, you don’t have many options. Even if you aren’t facing legal action yet, you could soon. So waiting out the statute of limitations is risky. And once they successfully sue you, it’s too late.
That makes settling your student loans before you face litigation an attractive option.
How Much Student Loan Settlement Could Save You
On federal loans, you’re unlikely to save more than 15%. The ED could offer more with a discretionary compromise, but it’s unlikely, and there’s not much you can do to increase your savings, no matter how long you’ve owed the debt.
But on private loans, you could save more, between 25% and 60%. And your specific circumstances and the actions you take to settle the debt can have a tangible impact on the amount you ultimately pay.
For example, the longer the debt has been outstanding, the more willing the debt collector may be to settle for less.
A collector may also be willing to settle for less if you can prove it’s in their best interest. For example, if you have a very low income, there isn’t much point in suing you since even garnishing your wages or bank accounts won’t net much for the lender.
And finally, if you have a strong legal case against the lender for violations of the Fair Debt Collection Practices Act, it may not be worthwhile for them to take you to court. Each violation comes with a penalty of $1,000. That gives you a strong case for a lower settlement.
For example, several years ago, my private student loan lender wouldn’t defer or forbear my loan while I was briefly unemployed. But because I had no income, I couldn’t pay the bill. The loan went into default, and they attempted to collect.
In the process, I was subjected to numerous harassing phone calls. The lender called at all hours and even threatened me on the phone. Worse, they called my family members. They called my brother on his cellphone, called my father at work, and even yelled at my sister on the phone.
In total, I documented over 100 harassing phone calls. That meant the lender could have owed me more than $100,000 had they tried to sue me and I countersued and won. Thus, it would have been more worth their while to settle the debt for a nominal amount if a class-action lawsuit hadn’t changed my game plan.
But keep detailed records of any violations. A court can’t rule in your favor without documentation.
And note that there’s a statute of limitations of one year on violations of the act. That means you can’t file a claim beyond one year after the violation, no matter how much evidence you’ve documented.
Downsides of Student Loan Settlement
Despite its obvious benefits as a way out of default, settlement has its downsides.
It Can Damage Your Credit Score
Typically, most of the damage to your credit score is already done by the time you settle your loans. The default and delinquency of all those missed payments will hit you the hardest.
A settlement could still drop your score anywhere from 60 to 100 points.
Settlement doesn’t entirely remove the adverse history from your credit report. Although it will no longer show a default, your report will show that you settled for less than you owed.
Lenders view settlement as derogatory, so it impacts your score just like default and missed payments. And the settlement stays on your credit report for seven years before falling off.
However, other actions, like a judgment or collections, can have a far greater impact. And since your score has already taken a hit from the default, it’s possible you won’t see much further impact from the settlement.
And once you settle your loans, you can begin rebuilding your credit.
You Need to Have a Lump Sum
If your loans are in default, it probably means you don’t have a considerable amount of spare cash squirreled away, right? But a stash is exactly what you need.
If you’re settling federal student loans, you absolutely must have a lump sum, as the government requires you to pay the full settlement amount within 90 days of the agreement. And for federal loans, that could be as much as the entire loan balance.
And while most private lenders will let you make installment payments, you’ll typically only have between one and three years to complete the settlement.
Plus, you’ll generally get much better offers if you can make a lump-sum payment. The lender has more confidence it can collect when it gets all the money at once.
You May Need to Hire Help
Although you probably found yourself in this situation because you couldn’t afford your payments, settling it may mean hiring help.
It’s possible to negotiate with your creditors on your own. But you may feel more comfortable hiring a private debt negotiator or lawyer, especially one experienced in dealing with student loans.
And if your lender sues, you need a lawyer to help you. Don’t try to fight high-priced corporate lawyers on your own.
However, shouldering the cost of a lawyer’s or debt negotiator’s services on top of saving money to settle your loans could be overly burdensome.
You Won’t Save Much With a Federal Student Loan Settlement
There isn’t much benefit to a federal student loan settlement. The ED’s extraordinary powers to collect give it little incentive to settle at all. And even when it does agree to settle, it’s rarely a good deal for the student loan borrower.
While the savings vary depending on the breakdown of your loan balance between principal and interest, a federal student loan settlement always results in only a marginal reduction of the overall balance. And you must produce the entire lump sum within 90 days.
You Have to Pay Income Taxes on the Canceled Amount
When you settle a debt and the lender cancels part of it, you have to pay income taxes on that amount. The IRS generally considers canceled debt income, so the amount of canceled debt is taxable and you must report it on your income tax return.
That includes student loans canceled, forgiven, or discharged outside certain qualified federal programs, such as the Public Service Loan Forgiveness Program or Perkins loan forgiveness.
Note that if you have a co-signer on any of your settled loans, the tax consequences might also impact them. You and your co-signer should consult with a tax professional before proceeding with a settlement negotiation.
Strategic Default to Get a Settlement
Some borrowers consider strategically defaulting to force a settlement. But defaulting intentionally isn’t a winning strategy.
Deliberately defaulting on your loans to force a settlement is technically a form of fraud. But even if you were to get away with that, there are too many potential consequences to a default.
Student loan default wrecks your credit. (Take it from me, I know.) You’ll also open yourself up to litigation from your lender. And for all that, you may not even get the settlement you want.
In fact, you could end up in a worse position than you started. For example, if you have federal student loans and the ED is unwilling to settle — which is likely — you’ll have racked up additional fees and interest on top of the original balance.
Moreover, if you’re defaulting on federal student loans to force a settlement, it’s absolutely not worth it. The ED can collect on unpaid loans without having to sue you first, their settlement deals won’t save you much, and there are tons of federal repayment programs and better alternatives to default.
Plus, you’ll lose eligibility for federal student loan forgiveness programs and new federal student aid.
In most cases, settlement should be a last resort since it damages your credit. But if you’re struggling to make payments or are currently in default, you can contact the company handling your student loans to find out whether there are other options, such as:
- Temporarily suspending payments through deferment or forbearance
- Reducing your monthly payment with an income-driven repayment plan
- Student loan rehabilitation
- Refinancing or consolidation
The options available to you depend on whether you have private or federal student loans.
But if you’ve exhausted all options, you may have no other choice but to file bankruptcy or attempt to settle. Since settling your student loans can be tricky and your choice can impact your finances greatly, it pays to get help from someone who specializes in student loans.
Find free borrower assistance at The Institute of Student Loan Advisors. Book a consultation with a financial counselor from the National Foundation for Credit Counseling. Or use an online attorney directory, such as the one at the National Association of Consumer Advocates, to find a lawyer who specializes in student loans.