Don't Count on Settling Those Student Loans

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Elie Mystal at Above the Law has a piece on what it's like to live as a student loan defaulter. There's a lot of back and forth in the comments as to whether Elie is a terrible human being or a terrible victim of rapacious banks, about which I will not comment except to make two points:


1) Law schools are a huge profit center for universities (high fees, low costs) so if you want to pin the blame for student loans on someone, this is a more appropriate place to look.

2) As someone who graduated from business school with nearly $100,000 in student loans, and whose first permanent full-time position paid $40,000 a year in New York City, I feel entitled to say that for anyone with a professional degree, defaulting on your loans is a choice, not something that just happens to you.

But that debate is not what interested me about the post.  This is what I found interesting:

Here is the question from a reader: 
 I want to stop paying my loans, force them into default, and once they have been sold to a collection agency (probably at less than face value), pay an agreed lump sum to discharge all my loans. Have you heard of anyone doing something similar? If so, what did the collection agency agree to in order to discharge the loan (50 cents on the dollar?).What are the repercussions besides the low credit score? Do legal employers look at credit score when making hiring decisions? Your advice would be appreciated. 
To be clear, I did not force my student loans into default as part of some self-directed plan. I'm not that smart. And if I had it to do over again, I probably would have found some way to make minimum payments on everything. Some people, especially landlords, treat people with low credit scores worse than ex-convicts. I am not advocating a plan to send your debt into default.

But 50 cents on the dollar? Don't give them that much, bro'. If I had the money, I could get out from under my debts for about a third of the principal that I still owe. Easy.
It's interesting because this is basically the exact opposite of what I've always been told about student loans.  

You will be unsurprised to hear that Mystal's correspondent is not the first person to think of doing this.  In fact, the default rate on student loans during the first two years out of school is almost 7%.  Once they've consumed the education, a large number of students seem to decide that it wasn't worth it, and that therefore someone other than them should have to eat the cost.

Because it's such a common idea, Congress has made it very difficult to shed student loan debt.  No student loans, not even the private ones, can be discharged in bankruptcy.  As a result, all the personal finance experts I've ever listened or talked to say that they're incredibly hard to get rid of.  

From what I hear, your federally guaranteed student loans (for me, about 40% of my debt IIRC) simply will not settle for less than the principal of your loan.  The bank has no incentive to settle at all, because the loans are guaranteed, and the government has no interest in settling.  Why should they?  If you don't pay, they can (and will) seize your income tax refunds, even your Social Security checks, to pay off the loans.  Unlike private creditors, they do not even need to go to court in order to get a garnishment order--and because federal laws trump state law, they can garnish up to 15% of your wages even in states where it's not allowed. And they've got an income-based repayment plan that makes these loans affordable for the genuinely strapped.

Private lenders have more incentive to settle, but not a great deal more.  Most unsecured debt, like credit card balances, personal loans, and medical bills, can and will be settled for pennies on the dollar--as low as ten cents in some cases (though this usually means that they don't have any verification of the debt, so I wouldn't take a settlement this low.)  It's not unheard of for a credit card collector to take 25 cents on the dollar on a valid debt, and 50 cents on the dollar is eminently achievable for many people.

But my understanding is that student loans are the great exception to this rule.  Why?  Student loans are not bankruptable, not even private ones.  A collector for normal sorts of unsecured debt is always working with the threat of bankruptcy in the background; if you try to hold out for full repayment, the debtor can always file Chapter 7.  In most cases, that means that unsecured creditors get nothing.

But that's not the case with student loans.  There are only two ways to erase the debt: prove you're permanently disabled and will never again earn more than a pittance; or die.  

Moreover, student loans are large, which means they're worth suing over.  Creditors can correctly assume that most people with a college diploma, or a law degree, are eventually going to have something worth taking: a bank account they can seize, a salary they can garnish.  Everything I have ever heard indicates that there is little chance of settling a student loan for less than the principal, and that even that is far from a slam dunk.  If the interest has been accruing for a decade or so and is now multiples of the original value of the loan, the lender may waive some of it, but not necessarily all of it.  Moreover, most of the amount forgiven counts as taxable income, including a lot of the back interest (any amount in excess of $2500--or all of it if you make more than $75,000 a year.)  

And of course getting a principal-only settlement requires you to amass a sum equal to the original principal of your student loan--without the creditor finding and seizing it.

In other words, my understanding is that most people who default and eventually "settle" their loans do so for . . . at least as much as they would have paid if they hadn't defaulted.  Attempting to walk away thus seems like an incredibly risky financial strategy compared to making your minimum payments every month and slowly working down the debt.

Now, I don't know what Mystal's situation is.  Maybe his debt has been sold to a collector who's offered him a fabulous settlement, or maybe his law degree is going to help him wrangle some deal that's not available to normal people.  

But unless everything I've ever been told about settling student loans is wrong, Mystal is giving people a dangerous misimpression that they can default and get their debt burden substantially reduced.  I've seen some cheering for his post on various blogs that link it, presumably because they think this is a way to really stick it to the banks.  But I would hate to see a lot of people follow his lead, and then find out that they've trashed their credit score--and in some cases, their employment prospects--in order to get a "deal" that's no better than what they could have achieved by just making their payments.  Can any readers comment? Anyone have success settling student loans for pennies on the dollar?

Update: Commenter SPQR9, who IIRC is a bankruptcy attorney, says

Like you, I think Mystal is completely wrong.  For that matter, last time I checked, student loans had no statute of limitations in addition to being largely non-dischargeable.  And the "hardship" provision through the DOE is largely "so you are a quadraplegic?  Well, maybe we'll give you a hardship discharge ..."

In other words: it's a very, very bad idea. And trying to stay judgement-proof for 60 years is likely to be more miserable than repaying your loans.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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