We hope the day never comes. The day when a client loses a job, faces extreme medical bills, or suffers a loss resulting in unexpected expenses. Suddenly, the budget you worked so hard to plan goes out the window. Your client is faced with being unable to pay their student loan debt.
At Capstone, we talk to families with the hope that we can plan beforehand for a college education our clients can afford without student loan debt, but let’s face it…most students will take on some debt in order to afford their education. 7 out of 10 students will take on some debt in order to afford their education. As financial advisors, we want to plan ahead so that amount is minimal.
When financial trouble comes though, it does not matter what the loan amount is. Your client is faced with a tough situation.
We want to review the terminology you need to know to understand the options available to your client. Helping them through this time with the right advice will be invaluable to your relationship. And even if your client never needs to consider these kind of situations, having this knowledge is just another part in the college funding lexicon.
Before we start talking about what happens when a client can’t pay, you may want to review the current repayment plan options available. Perhaps they are a good candidate for debt consolidation or income-based repayment plans? This is especially true if they have a job but are not making as much income as they need to make the loan payments.
If repayment plans won’t solve their problem and they really can’t make their student loan payments, what are their 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 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.
Deferment can last up to six months and sometimes longer. Some lenders will allow them to recertify their deferment every year for up to three years.
If the loan is unsubsidized, then the interest DOES accrue and is added to the 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 your client 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 interest is accruing, you can choose to make payments on the interest only.
If your client is not eligible for a deferment, they can apply for a forbearance. Forbearance is a period of time up to 12 months when loan payments are temporarily suspended or reduced and is granted by the lender.
Certain types of financial hardships can trigger forbearance. Your client wants to make payments but is simply unable to do so. Payments are postponed and interest does accrue. When interest is accruing, it is added to the total loan amount. To keep the principal from increasing, the client 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 your client falls within the following circumstances, they 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 possible.
On certain rare occasions, a student loan may be cancelled or forgiven if certain conditions are met. 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, your client may receive money back that they 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 the client can’t make their payments? They may face loan default. The first day of a missed payment the loan becomes delinquent. After 90 days of delinquency, loan servicers will report the delinquency to one of the three major credit reporting agencies. The credit history will now be impacted. A negative credit history affects a client’s ability to buy a car, rent an apartment, buy insurance, or even get a cellphone plan.
After 270 days of delinquency, the 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 plan
- 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 your client and prevent the buying or selling of real estate. In summary, they will face years of trying to rebuild their 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 your client is struggling financially.
Another option is loan rehabilitation. Under Direct and FFEL Program loans, your client can agree to make payments equal to at least 15% of their discretionary income. Payments may be as low as $5 per month depending on their income. Wage garnishment does not count as payments made by them. They also agree to make nine monthly payments within twenty days of the due date within a period of ten consecutive months. If they fulfill those requirements, their loan will no longer be considered in default. It will be rehabilitated.
Under Perkins loans, the monthly payment is determined by the school holding the loan. Your client 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, your client will regain access to deferment, forbearance, repayment, and forgiveness if applicable. The default will be removed from their 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, your client must agree to either:
- Repay the new loan under an income repayment plan OR
- Make three consecutive, voluntary, on-time, monthly payments
They can consolidate their loan into one of the available income repayment plans, and the new loan is eligible for deferment, forbearance, and loan forgiveness again. Their credit history will still reflect the loan default. It will not be removed from their history.
The term of a consolidated loan can last up to 30 years so be aware your client will be making more payments with more interest over a much longer time.
When it comes to having trouble paying a student loan debt, remember to look into whether or not repayment plans are a workable option for your client first. Also, examine their budget very closely. Are places where they can cut expenses available? As you know, getting rid of that student debt load as soon as possible is best for their financial health.
But those options are not always possible, and they need to consider deferment and forbearance. Be sure in all these situations that your client communicates with their lender. They will be much better to work with if the client is proactive in the conversation. Lenders do want to avoid default and working with them in advance will try to prevent that circumstance.