Federal Student Loans - Getting Out of Default


Bad things can happen to those who default on federal student loans. Borrowers may be subject to income tax intercepts, administrative wage garnishments, and seizure of some government benefits. If you are in default, you want to get out as quickly as possible. This post will talk about two ways to cure defaulted federal loans.

Consolidation. The first option is to consolidate defaulted loans into a new loan with a repayment plan that is based upon the borrower's income. Consolidation is generally pretty fast and there is no requirement that the borrower make any initial payments to qualify. The new loan is a Direct consolidation loan. There are two ways to obtain Direct consolidation loans. The first is for the borrower to make three consecutive payments, which must be reasonable and affordable considering her financial circumstances. It is important to note that this method is not a requirement but rather a method to obtain a Direct consolidation loan. The second approach is for the borrower to agree to go on an income-based repayment plan for the new loan and consent to the Internal Revenue Service disclosing tax information so that the borrower's income may be verified. There are no credit restrictions for obtaining Direct consolidation loans. However, a collection fee up to 18.5% of the amount consolidated may be added to the new loan. Although that amount may seem steep, it is still less than the collection charge of 25% which is usually tacked on to defaulted federal student loans. The Direct consolidated loan usually has a term of up to 25 years and the process to obtain this loan takes anywhere between 30 and 90 days. You can only cure defaulted federal student loans once through consolidation and there are some restrictions as to which loans may be consolidated.

Rehabilitation. The other way to cure a federal student loan default, rehabilitation, is the preferred method for collectors. This is because collectors earn more in fees through rehabilitation than they do through consolidation. Loans that have gone to judgment are not eligible for rehabilitation. Rehabilitation removes the word "default" from a borrower's credit report. Other than this credit solution, rehabilitation has no advantage over consolidation. To rehabilitate a defaulted Federal Family Education Loan (FFEL) or Direct loan the borrower makes nine payments within 10 months which are to be reasonable and affordable. This is where problems start to arise with rehabilitation. What is reasonable and affordable is based on a review of the borrower's finances which must be verified by documentation (paystubs, tax returns). However, collectors often times try to force borrowers to pay more than they can afford, thereby creating a problem with the rehabilitation payments from the outset. For FFEL loans, once the ninth payment is made the loan is usually sold to a new lender. As with consolidation, once the loan is sold to a new lender, collection fees up to 18.5% of the current principal balance may be tacked on to the loan. The Department of Education does not consider FFEL loans to be rehabilitated until the sale to the new lender is complete. This is where another problem with rehabilitation can arise; if the loan is not resold then rehabilitation is not complete. A borrower considering curing a defaulted FFEL loan through rehabilitation must take this possibility into account and consider consolidation, if available, as an alternative. Rehabilitated Direct loans are not sold to new lenders. To rehabilitate a Perkins loan nine consecutive monthly payments must be made. No payments may be skipped. Additionally, there is no requirement that the payments be reasonable and affordable. However, since Perkins loans generally carry a lower balance than other loans, the payments are usually reasonable. As with consolidation, rehabilitation may only be used once to cure a defaulted federal loan.