Student Loan Settlement: What It Is, What to Expect, and Alternatives

If you find yourself feeling overwhelmed with student loan debt, you might wonder if settling your student loan debt is possible. A student loan settlement is a way to potentially reduce your loan balance and negotiate specific terms to satisfy your debt.

Though it might sound like a simple solution for struggling borrowers, the option is available for a small subset of borrowers only — and even then, the benefit might be nominal.

What is a student loan settlement?

A student loan settlement is when you work with your private lender, federal loan servicer or collection agencies on a plan to “settle” the debt, ideally with better terms for you. The agreed-upon amount of a student loan settlement is typically lower than the original outstanding amount on the student loan.

When a settlement agreement is reached, the lender or collector and the borrower agree to a specific reduced amount that will satisfy the debt.

When is student loan settlement possible?

Although it’s possible to get a student loan settlement, it’s not very common or as beneficial as you might think. Student loan attorney, Adam S. Minsky, Esq., explained that it’s only an option for student loans in default.

Your federal student loans are officially in default after 270 days of non-payment. Private student loan debt enters default much sooner, typically after 120 days of not making a payment. The exact timeline varies, based on your private lender.

In addition to damaging your credit score, a defaulted student loan might be sent to a collection agency. Debt collectors will continuously contact you to collect on payment, which includes the original loan amount, plus interest and collection fees that add up.

“For defaulted federal student loans, a settlement would have to be in a lump sum, and federal guidelines limit how much of a balance reduction you could even get on a settlement involving defaulted federal student loans, resulting in only a marginal benefit at best in many cases,” said Minsky.

That lump sum can be a lot of money, making it not ideal for federal loan borrowers in default who are feeling the burden of debt. However, student loan settlements might be more suited for private student loan borrowers.

“Settlements on defaulted private student loans are variable. Because there are fewer options to resolve defaulted private student loans as compared to federal loans, settlement may be more ideal,” said Minsky.

Federal vs. private student loan settlement

Here’s the difference between a student loan settlement for federal loans, compared to private student loans.

Federal student loans

The benefits of a student loan settlement are particularly minimal for federal student loans because the U.S. Department of Education has many ways of recouping costs for defaulted student loans.

These strategies include:

• Wage garnishment
• Tax refund garnishment
• Social Security garnishment

In other words, there are ways for the government to recover student loan payments that don’t involve settling for an amount that’s less than you owe.

Generally, federal loan borrowers can only hope for changes, like reduced fees or interest rates, or a small balance reduction, when seeking a student loan settlement.

“There are three standard settlement offers that collection agencies are authorized to accept for lump-sum settlements of defaulted federal student loans,” said student loan expert ​​Mark Kantrowitz, publisher of PrivateStudentLoans.guru, “(1) Waive collection charges. (2) Forgive half of the interest that has accrued since the loan went into default. (3) Reduce the outstanding balance by 10%.”

These options are reserved for borrowers who’ve been in default for the long haul. If you’re thinking of defaulting just to settle your debt, you’re in for a disappointment. “Strategic default does not work because the starting point is always the loan balance when the loan went into default” Kantrowitz explained.

Private student loan debt settlement

Although student loan settlements might be more advantageous for a private student loan settlement, there are some important nuances to be aware of. For example, there’s a statute of limitations on private loans that can affect the possibility or need for a student loan settlement.

A statute of limitations refers to the timeline that creditors can legally attempt to collect payment from a borrower. Private student loans might have debt collection limits of three to 10 years, depending on the state.

“Federal student loans are not subject to a statute of limitations – only private student loans. Some borrowers may be able to get a more generous settlement if the debt is close to, or beyond, the statute of limitations,” explains Minsky.

Private student loans that are passed the statute of limitations, are considered “time-barred debt”. Since time-barred debt is outside the statute of limitations, it’s no longer enforceable so a creditor could no longer go after you for unpaid private loans.

This timeline is important for private student loan borrowers in default because taking any action on time-barred debt could reset the clock.

“If a borrower takes certain actions on time-barred debt, such as making a payment or offering to settle the debt, it can reset the clock on the debt, thereby making it collectible again,” explains Kantrowitz.

What to expect with a student loan debt settlement

If you’re in student loan default and want to pursue a student loan settlement, contact your lender first. Kantrowitz recommends having an attorney review the terms of any settlement offers before accepting them. This is especially important if you have a combination of federal debt and private debt which can get confusing to delineate in a settlement.

For example, the settlement amount may be for your private loans, but not your federal debt. You want a professional who can break down the settlement agreement.

If you move forward, you’ll need to pay the full, lump-sum amount. Afterward, you'll receive a “Paid in Full” statement and keep it for your records.

You might be able to ask the lender to remove the default from your credit history. If that’s not possible, it will take several years for it to drop from your credit report.

On top of credit implications, there might be tax consequences for borrowers and their cosigners.

“Borrowers should understand that the borrower will receive a 1099-C for the amount of debt that was canceled and that this may be treated as taxable income to the borrower. It's as though someone provided the borrower with the money to pay off the debt,” said Kantrowitz.

If you’re considered insolvent, where your total debt exceeds your total assets and your financial situation is dire, you might get off the hook for taxes or get approved for a payment plan. If you have tax questions, it’s best to contact a tax professional.

Alternatives to a student loan settlement

Student loan settlement might be out of reach for most people as it requires a lump-sum payment that not many borrowers have available. For federal student loan borrowers, there are other options to get out of default:

• Student loan rehabilitation. If you have defaulted federal student loans, contact your loan servicer to rehabilitate your loan accounts. This path requires borrowers to make nine months of affordable payments within a 10-month period.
• Direct Consolidation Loan. Your other option out of default is to consolidate your federal loans that are in default with a Direct Consolidation Loan. You would need to repay it under one of the four Income-Driven Repayment (IDR) plans. Alternatively, you can make at least three months of full payments before consolidating.

If your federal loans aren’t in default yet, but you’re struggling to manage student loan payments, here are a few options to discuss with your student loan servicer:

• Income-driven repayment plan. If you’re facing financial hardship and have federal loans, consider going on an income-driven repayment plan. IDR plans may offer $0 monthly payments and keep you in good standing.
• Deferment or forbearance. Request a deferment or forbearance to temporarily pause your loan repayment.
• Student loan forgiveness. Federal loan borrowers can look into loan forgiveness programs such as Public Service Loan Forgiveness (PSLF) and forgiveness under IDR.

Alternatives for private student loans

If you have private student loan debt, talk to your lender to negotiate a reasonable repayment plan, or learn about your available forbearance options.

Private student loan borrowers can also consider student loan refinancing to get a lower interest rate. When you refinance, your new loan private refinancing lender repays your original loan and creates a new refinance loan. Ideally, at a lower interest rate or terms that make your student debt more manageable.

In very rare instances, discharging student loans in bankruptcy is possible but is hard because of the “undue hardship” rule. Undue hardship is when your loan repayment has a significant impact on your life.

Bankruptcy courts have varying definitions of what undue hardship looks like, but if paying back the loan would cost you a basic standard of living or if the financial hardship is likely to last a long period, you may qualify for the undue hardship rule.

Get student loan help

If you need knowledgeable advice regarding a student loan settlement and your legal options, consider contacting a student loan lawyer.

If you need strategic advice regarding student loan repayment, book a consult to get customized student loan support.