Student Loan Settlement: How to Negotiate a Payoff

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Updated on January 16, 2023

Student loan settlements are possible to get, but you can’t just call the lender and offer to pay what was originally borrowed and get a deal. Your offer, although fair, will be rejected. That’s not how the process works.

Here’s what it takes to negotiate a student loan payoff for less than the current balance:

  • The loans must be in default.

  • The loan holder must believe that it can make more money by accepting less money today than it could if it took you or your cosigner to court to get the right to garnish your wages, seize the money in your bank account, and put a lien on your home.

  • You must be able to pay the settlement amount in a lump sum within a few days or over a handful of payments.

You can settle federal and private student loans in collections, but you can’t settle a student loan in good standing. So if your loans are in deferment, forbearance, or an interest rate reduction program, you won’t be able to reach a student loan settlement or eliminate some of the interest. You must miss several monthly payments in a row before that option opens up.

Related: Private Student Loan Debt Settlement: How It Works

When you can negotiate a student loan payoff

To settle student loan debt, your loans must be in default. Federal student loans enter default after you miss payments for nine straight months. Private student loans typically default after you skip payments for four to six months.

You can’t force a settlement because you’re facing financial hardship or are willing to pay what you borrowed today.

Why you must miss payments before you can settle

Lenders will settle student loan debt after the borrower has fallen behind on payments and eventually defaults. This is because it stands to gain something rather than hoping the borrower makes payments again. If the borrower is paying on time, the lender has no incentive to accept a settlement as they’re receiving what they’re due per the terms of the promissory note.

Related: Can You Pay Off Student Loans in One Lump Sum?

This policy makes sense when you think about it. The longer you take to pay back the loan, the more interest you’ll pay. Sure, the lump sum you’re offering today is a large cash injection. But your lender typically has a much longer horizon when looking at its accounts. Banks and their investors want you to take as long as possible to repay the debt so they can make more money.

Skipping out on student loan payments changes that dynamic. This is why some borrowers consider a strategic default on their student loans. But missing payments isn’t without risks.

Settling student loan debt hurts your credit — at first

There’s no getting around it: your credit score will take a hit if you want to settle your student loans. The hit you’ll take depends on how many loans you have and how long it takes to strike a deal. Each missed monthly payment for each loan will add a late payment to your credit history, so the more loans you try to settle, the bigger hit to your score.

But the blow can be temporary. You can quickly recover from the damage if you reach an agreement with your student loan lender soon after defaulting rather than letting the defaulted loans languish for years.

Most of my clients report that their FICO scores returned to pre-default levels or higher within 18 months of paying the settlement in full. Of course, every situation is unique. That’s why I recommend working with a credit repair professional as part of the settlement process. They can review your credit reports from all three bureaus to determine the best ways to rebuild your score, including removing the settlement accounts.

Consequences of defaulting on federal loans

If you default on federal student loans, you’ll lose eligibility for student loan forgiveness programs such as Public Service Loan Forgiveness, income-driven repayment plans, and new federal student aid. Collection costs will be added to your balance, and your name will be listed in CAIVRS, making it impossible for you to obtain an FHA, USDA, or VA home loan. Furthermore, you’ll be subject to wage garnishment, tax refund offset, and Social Security benefits offset.

Consequences of defaulting on private loans

If you fail to make payments on your private loans, the servicer will report your account as delinquent to the three major credit bureaus. Your loan servicer and debt collector will call you nonstop as well. They will call your family, friends, and employer to shame you into paying if you ignore them. Fortunately, that’s all they can do. Unlike the Department of Education, private lenders cannot take money from you or place a lien on your home until they sue you and obtain a judgment.

How to settle your student loans

Before you begin negotiating, contact your student loan servicer to determine whether your loans are near or are already in default.

Be careful: when you contact the servicer, they may offer you a forbearance or alternative repayment plan, such as interest-only payments for a limited time. Accepting one of those options may bring your account current and restart the negotiation process.

Here are 5 steps to negotiate a student loan settlement.

Step 1 – Know what you can afford

Check your finances to know how much cash you can put your hands on and when it will be available. Look at your savings, 401k, inheritance, credit card cash advance limits, family members, pay stubs, and monthly expenses to learn what you can afford in a lump sum and per month.

Depending on your credit, you may be able to borrow a personal loan to help pay the settlement.

Step 2 – Know what type of loans you’re settling

You’ll get a better deal settling federal student loans than you will with private student loans.

The company that handles collections for federal loans, Default Resolution Group, will waive the collection charges and half of the outstanding interest but none of the current principal balance. The fact that the principal is greater than what you borrowed initially — called negative amortization — is irrelevant. The federal government can afford to reject reasonable offers because it knows three things about federal student loans:

  • They don’t have a statute of limitations.

  • They are difficult to discharge in bankruptcy.

  • Debt collectors for federal loans can garnish your wages, take your tax refund, and seize Social Security benefits without a court order.

Private lenders, banks, and online financial institutions don’t have the same benefits. Their loans do expire, they are easier to get rid of in bankruptcy, and they must sue you before taking money from your paycheck or bank account or putting a lien on your home.

A private student loan settlement can save you a lot of money. The amount you save will differ greatly depending on the lender. Some companies will accept as little as 35% of the current loan balance. Others demand a lump sum of up to 75%.

If you’re not sure what type of loans you have, check Any loan listed on the Federal Student Aid website is a federal student loan. If your loan isn’t listed there, it’s likely a private student loan.

Learn More: How to Find a Student Loan Debt Settlement Lawyer

* A while back, the U.S. Department of Education published a manual with guidance on the settlements, or what it called compromises, collection agencies could accept from federal student loan borrowers. IMO, that manual is no longer relevant. The only offer the department has been willing to accept for its debts — no matter the financial hardship — is the Standard Compromise, which is a waiver of the collection fees and some of the unpaid, noncapitalized interest.

Step 3 – Contact the collection agency

Ask the representative for the repayment options on your defaulted loan. If they don’t offer you a settlement, ask if settlement is an option and, if so, how much they will accept. At this point, the representative may ask you about your personal finances, marital status, etc. Try to avoid giving too much detail until you get an offer. Once you get an offer, you can either accept it or counter it.

Here’s a tip: If you’re unsure how to get a settlement offer, summarize your loan history, personal struggles, and current financial situation, and ask, “Given my situation, what can we do to resolve this debt as soon as possible?”

There are three types of settlement offers student loan creditors accept:

  • Lump sum settlement – you make one large payment to settle the outstanding balance for less than what’s owed. You usually get the biggest discount with this type of settlement agreement.

  • Monthly payment – you agree to make payments over several months up to a handful of years. If you miss a payment, the offer is canceled, and you owe the full loan amount minus any payments you’ve made.

  • Lump sum plus monthly payment – you make an initial lump sum payment and installment payments until the reduced balance is paid in full.

Most federal student loan settlements are for a lump sum because you must usually pay it in three months or less. Private student loan debt settlements typically offer more flexible terms. Your deal will depend on the lender, collection agency, loan age, balance, and other factors.

Step 4 – Review the offer

If you can reach an agreement, make sure you get the offer in writing. An email is fine. A letter is better. When you get the offer, review it to make sure:

  • the loan ID numbers are listed

  • your name and contact information are correct

  • the settlement payment plan terms are listed (lump sum, monthly payment, payment date, etc.)

Step 5 – Pay the settlement

Submit payment by following the payment instructions outlined in the offer letter. Typically, you can pay using a check, money order, debit card, wire transfer, or by setting up an auto draft. Many lenders won’t accept credit card payments, so you won’t be able to rack up points at the same time.

What to expect after settling

After you make your payment and fulfill the terms of the settlement, you’ll receive a clearance letter. This document will serve as proof that you’re no longer liable for the particular student loan.

At the end of the year, the IRS will send you a Cancellation of Debt notice (a 1099-C). The unpaid portion of your student loan is reported as taxable income on a 1099-C. You must include this in your tax returns and will almost certainly have to pay income tax on it.

Skip taxes with this: The IRS has a procedure that allows you to avoid paying taxes on the canceled amount if you’re considered insolvent. Consult a tax professional to see if you’re eligible.

Who can help you negotiate student loans?

With student loan settlement negotiations, you have three options:

Negotiate yourself. Nothing is stopping you from doing it yourself and contacting the debt collection agency that has your student debt to offer a settlement. But be careful about resetting the clock on old private student loan debt by agreeing you owe the loans and making payment arrangements. Federal student loans never go away, so you don’t have to worry about restarting the statute of limitations.

Hire an attorney. A student loan lawyer specializing in debt settlements can negotiate a settlement for your federal or private student loans. Hiring an attorney doesn’t guarantee a result or that you’ll save more money than if you tried to settle the matter on your own. That said, a lawyer experienced in negotiating settlements with specific lenders knows what’s a reasonable settlement offer.

Work with a debt settlement company. Debt settlement companies help by having you stop paying your lender and then make payments to the company. The company rarely starts negotiating until you’ve paid their fee in full, which may be several years later. Late payments will be added to your credit report during that time, lowering your credit score in the process.

Related: Can a Lawyer Negotiate Student Loan Debt?

‍Alternatives to settling student loans

You still have options to get out of your student loan debt even if your financial situation doesn’t allow you to settle.

Ask your loan servicer about the student loan repayment options available to you. Keep in mind that your options will be limited if you’ve already defaulted. You’ll no longer be eligible for income-driven repayment plans or forgiveness opportunities. You may be able to restore those benefits for federal loans by applying for loan consolidation or entering into the loan rehabilitation program.

On the other hand, private lenders rarely offer a way to recover from loan default. So before you fall too far behind on your payments, speak with your servicer about ways to lower your monthly payments. Depending on your credit, refinancing your loans may help you score a lower interest rate and longer repayment term, which can lead to a more affordable bill. Use an online marketplace like Credible to shop for the best rates with multiple lenders.

Student loan refinancing options are limited if you default on your private loans. I know only one company that refinances defaulted private student loans: Yrefy.

Need expert advice about your student loan settlement?

Hiring a lawyer is often the right choice to ensure you negotiate the lowest settlement amount possible. Schedule a call with me to discuss your settlement options and figure out the right path for you to finally escape your student loan debt with minimal harm to you and your cosigner.

UP NEXT: Can You File Bankruptcy on Student Loans?

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