Life can get difficult and overwhelming sometimes. People lose their jobs, they get sick, they have major unplanned expenses. And when that happens, student loans are often the first to become past due.
The unfortunate reality is that defaulting on student loans can be surprisingly easy. For private student loans in particular, just missing a handful of payments can result in the account being placed in default status. This can have very serious consequences for the borrower. By definition, being in “default” means that the loan contract has been broken, and the full balance of the loan has been declared to be due immediately (this particular element of default is called “acceleration”).
Here’s what can happen next.
A negative mark on your credit report is one of the major, immediate consequences of student loan default. The late payments leading up to default will be reported to the major credit bureaus as well the default itself, along with a notation that the loan may be in collections or transferred to a different entity.
This can tank your credit score overnight. And the negative reporting continues while the student loan remains in default, leaving a long trail of destruction in your credit history. The negative credit reporting might make it difficult to rent an apartment or get approved for a mortgage. Obtaining a car loan or any sort of line of credit could also be problematic. Some employers, especially in the financial sector, conduct background checks, and they might request a copy of your credit report which could jeopardize your prospects.
Another major consequence of student loan default is a financial penalty – called “collections charges” – that can assessed on the underlying loan balance as a result of default. For federal student loans in particular, federal law allows for massive collections charges and penalties to be assessed on defaulted loan balances. Federal courts have upheld penalties and collections charges of up to 25% of the combined principal and interest balance for defaulted federal student loans.
For private student loans, it’s a little more variable. If the private student loan contract allows for penalties and collection charges, and those charges are reasonable as defined by state law, then you might see collections charges assessed on private loans as well. But that’s not always the case.
Transfer to Collections
Once a student loan goes into default, it’s usually removed from the loan servicer that was handling the account while it was in good standing. The account may then be placed with a third-party debt collector.
These debt collection agencies can be quite aggressive in pursuing borrowers in default, and sometimes they run afoul of the law. In addition to the standard threatening letters, debt collectors sometimes call people excessively, misrepresent the nature of the debt or the borrower’s rights, and they may contact people who have nothing to do with the underlying student loans.
Under federal law (and under state law in many cases, as well), some of these practices are illegal. Debt collectors are prohibited from engaging in practices that are unfair, deceptive, or abusive.
One of the most severe consequences of student loan default is the possibility of a lawsuit.
Federal student loan lenders, including the U.S. Department of Education, rarely sue defaulted student loan borrowers because the government has so many powerful collection tools at their disposal that don’t require a court appearance.
However, it’s quite common for private student loan lenders to sue borrowers in state court because obtaining a judgment is often the only way they can go after a borrower’s property or income. What a student loan lender can do depends largely on state law.
If the student loan default isn’t ultimately resolved, the borrower may eventually be subject to wage garnishment for federal student loans. Federal lenders and the government can garnish wages “administratively.” This means that they don’t need to go through the court system or secure a judgment in order to take a portion of a borrower’s wages. All they have to do is find your place of employment and give you notice that they are going to garnish, along with the opportunity to contest that proposed garnishment.
Private student lenders generally don’t have quite the same powers. They have to first go through the court system – they must sue the borrower and secure a judgment. Only then can they potentially go after a borrower’s wages – and their powers (or lack thereof) is determined by state law.
Tax Refund Seizures
One of the most powerful tools that the federal government has to pursue federal student loan borrowers is the ability to intercept your federal tax refunds. This is accomplished through a program called the Treasury Offset Program, and it allows the IRS to seize your federal tax refund and apply it to your federal student loan debt.
This can be particularly destructive to lower-income borrowers who may need their tax refund to pay for routine living expenses. This can also be problematic for married couples who file taxes jointly; the couple’s entire joint tax refund can be seized, although in some cases the spouse that is negatively impacted by the seizure may have recourse by filing something called an “injured spouse’s claim.”
Luckily, as a general rule, private student loan lenders cannot take your federal tax refunds.
Social Security Offset
The Treasury Offset Program isn’t just about federal tax refunds. The program also allows the federal government to seize a portion of your Social Security payments in some cases. This can have a devastating impact on older borrowers who are often on a fixed income.
Just like with administrative wage garnishment, borrowers are entitled to notice and an opportunity to contest any Social Security offset before it takes place. And under most state laws, private student loan lenders cannot go after a person’s Social Security benefits through the state courts.
The Bottom Line
Defaulting on student loans can have very serious and lasting consequences, upending a person’s life. But the good news is borrowers may have options to get out of default.
For federal student loans, there are statutory programs available (like rehabilitation or consolidation) that can allow borrowers to cure their defaults, restore their loans back to good standing, and start repairing their credit.
Private student loan defaults are sometimes tougher to resolve. But in some cases, borrowers may have viable defenses to collection that can help them avoid any resulting judgment. Other borrowers may be able to negotiate a settlement, resulting in a substantial reduction in their balance.
The bottom line is that as bad as default is, in many cases it’s fixable. If you find yourself facing default, now might be a good time to talk to a professional and find out what your legal rights and options may be.