What happens when you can’t pay your student loan bill?
By Joe Messinger, CFP®
March 10, 2017
We hope the day never comes. The day when you lose a job, face extreme medical bills, or suffer a loss resulting in unexpected expenses. Suddenly, the budget you worked so hard to plan goes out the window. You are faced with being unable to pay your student loan debt.
At Capstone, we talk to families with the hope that we can plan beforehand for a college education you can afford without student loan debt, but let’s face it, 7 out of 10 students will take on some debt in order to afford their education. We want to plan ahead so that amount is minimal, but life happens.
When financial trouble comes though, it does not matter what the loan amount is. You are still faced with a tough situation. We want to review the terminology you need to know to understand your options.
Before we start talking about what happens when you can’t pay, you may want to review the current repayment plan options available to you. Perhaps you are a good candidate for debt consolidation or income-based repayment plans? This is especially true if you have a job but are not making as much income as you need to make the loan payments.
If repayment plans won’t solve your problem and you really can’t make your student loan payments, what are your options?
(Note that bankruptcy is not always an option. Student loan balances are not automatically discharged by bankruptcy. You can read more about the rare instances here.)
The terms we’ll talk about here are deferment, forbearance, loan cancellation, and loan default. Please note we’ll be talking about federal loans here–not private ones.
Deferment is a postponement of your payments on the loan. This postponement is the right of the loan holder under certain conditions. During this period, interest does NOT accrue for Direct Subsidized Loans, Subsidized Federal Stafford Loans, and Federal Perkins Loans. The government pays the interest for you.
Deferment can last up to six months and sometimes longer. For some situations, certain lenders will allow you to recertify your deferment every year for up to three years.
If you have a different type of federal loan (Unsubsidized), then the interest DOES accrue and is added to your principal balance. (Need a student loan refresher? Refer to our blog post on the subject.)
Because deferment is a right of the loan holder, the lender does not have the option to deny it. The conditions that make you eligible for a deferment are:
- Enrolled at least half time in a postsecondary school or are in graduate school
- Are in one of the following: Peace Corps Service, active duty, National Guard or other reserve (called to active duty)
If your interest is accruing, you can choose to make payments on the interest only.
If you are not eligible for a deferment, you can apply for a forbearance. Forbearance is a period of time up to 12 months when your loan payments are temporarily suspended or reduced and is granted by the lender.
Certain types of financial hardships can trigger forbearance. You want to make your payments, but you are simply unable to do so. Payments are postponed and interest does accrue. When interest is accruing, it is added to your total loan amount. If you want to keep the principal from increasing, you must make interest payments.
Variable interest rates will remain variable.
Unlike deferment which is a right, forbearance is not and must be approved. Even if you fall within the following circumstances, you might not be approved for forbearance. The circumstances when you can try to have your loan reduced or suspended are:
- Teachers in a teacher shortage area
- Unusual life circumstances
- Financial hardship (incl. exhausting your unemployment deferment)
- Loan repayment history is good
- Poor health
- Medical/dental internship residency
- Governmental volunteer service (like AmeriCorps)
In both deferment and forbearance situations, you must apply to the lender to be approved. There’s always paperwork, right? Be sure to keep careful records and continue with payments if you can.
On certain rare occasions, your student loan may be cancelled or forgiven if you meet certain conditions. Two of the situations when a loan may be discharged include “total and permanent disability” or teacher loan forgiveness. A complete list of situations where student loans may be cancelled can be found here. Cancellation due to any given situation may depend on the different federal loan types (Perkins, Direct, Federal Family Education Loan “FFEL”) as well.
If a loan cancellation is approved, you may receive money back that you have already paid. Also, any bad credit history may be deleted. Cancellation must be approved by the lender or in the case of Perkins loans by the school.
What happens when deferment, forbearance, and cancellation will not work, and you can’t make your payments? You may face loan default. The first day you miss a payment your loan becomes delinquent. After 90 days of delinquency, loan servicers will report the delinquency to one of the three major credit reporting agencies. Your credit history will now be impacted. A negative credit history affects your ability to buy a car, rent an apartment, buy insurance, or even get a cellphone plan.
After 270 days of delinquency, your loan goes into default. The impact of default is severe. The entire loan amount including interest becomes due and payable in full. Plus, the amount due will increase because of late fees, collection fees, attorney’s fees, and other costs which quickly escalates the amount due. In certain cases, the fees may end up exceeding the original amount due.
In addition, you will/may:
- Lose eligibility for deferment, forbearance, or repayment plans
- Lose eligibility for future federal student aid
- Have your loan assigned to a collection agency
- Forfeit any federal or state tax refund to be applied to the outstanding balance
- Suffer wage garnishment from your employer (Federal employees face Federal Salary Offset.)
The lenders may take legal action against you and prevent your buying or selling of real estate. In summary, you will face years of trying to rebuild your credit and recover from default.
Is there any way to recover from default? Yes. The most obvious is to repay the loan amount in full. Probably not the most practical when you are struggling financially.
Another option is loan rehabilitation. Under Direct and FFEL Program loans, you agree to make payments equal to at least 15% of your discretionary income. Payments may be as low as $5 per month depending on your income. Wage garnishment does not count as payments made by you. You also agree to make nine monthly payments within twenty days of the due date within a period of ten consecutive months. If you fulfill those requirements, your loan will no longer be considered in default. It will be rehabilitated.
Under Perkins loans, your monthly payment is determined by the school holding your loan. You must make full payments every month within twenty days of the due date for nine consecutive months.
You can only rehabilitate a loan once. But once you do, you will regain access to deferment, forbearance, repayment, and forgiveness if applicable. The default will be removed from your credit history but not the late payments from before the loan defaulted.
A third option to get out from a loan default situation is loan consolidation. You can consolidate one or more federal loans with a new one at a fixed interest rate. To consolidate, you must agree to either:
- Repay the new loan under an income repayment plan OR
- Make three consecutive, voluntary, on-time, monthly payments
You can consolidate your loan into one of the available income repayment plans, and the new loan is eligible for deferment, forbearance, and loan forgiveness again. Your credit history will still reflect the loan default. It will not be removed from your history.
The term of a consolidated loan can last up to 30 years so be aware you will be making more payments with more interest over a much longer time.
When it comes to having trouble paying your student loan debt, remember to look into whether or not repayment plans are a workable option for you first. Also, examine your budget very closely. Are places where you can cut expenses available? Getting rid of that student debt load as soon as possible is best for your financial health.
But those options are not always possible, and you need to consider deferment and forbearance. Be sure in all these situations to communicate with your lender. They will be much better to work with if you are proactive in the conversation. Lenders do want to avoid default and working with them in advance will try to prevent that circumstance.