Student Loan Settlements, Revisited

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Eli Mystal says that I misread his post last Thursday:

On Thursday night, I tried to explain the ups and downs of living your life under constant threat from debt collectors. Based on the reaction to the post, I have to say that the reading comprehension of my post was poor, even by "internet commenter" standards. Even Megan McArdle in The Atlantic missed some of the key points in my post.
Mostly, I blame myself. When that many people gloss over things in your post, chances are you didn't make things clear enough. So allow me to correct that problem now. This time, I'll use capital letters and aggressive fonts to make sure we're all on the same page: when it comes to negotiating down your educational debts for less than the principal, I AM NOT TALKING ABOUT FEDERAL LOANS. You should never, ever mess around with your federal debt because Uncle Sam ALWAYS GETS HIS MONEY.

Are we clear?

McArdle also claims that she doesn't know anybody who successfully negotiated down their student debts with their lenders (missing again my point that my debts had already been sold to a collection agency). McArdle's skepticism sounds to me like a person who goes to a car dealership, pays sticker price, and then wonders why everybody was high-fiving the dealer as she drives off the lot.

But these factual issues are not what interested me about McArdle's post. What I found interesting was the subtle scorn she (and many commenters) had for those who do not pay back their debts. I should have included that scorn in my list of things that happen when you default on your loans...

He shouldn't blame himself for being unclear; he was perfectly clear.  He should blame himself for poor reading comprehension, since I understood that he was talking about his private loans, and that they had been sold to collectors, facts I mentioned right there in the post:


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. 
I don't know why Mystal thought I was only talking about federally guaranteed loans, or that I didn't understand that his debt had been sold to a collector, but there you are. If I had thought that he was talking only about federally guaranteed loans, I would simply have said "Mystal is dangerously deluded and needs to issue a correction immediately before someone gets a very harmful idea from his post."  Federal loans don't settle.  Period.

Private loans are somewhat more likely to settle, but from everything I hear--not from my friends in default, but from various sorts of experts in personal finance--private loans almost never settle for anything like 33 cents on the dollar.  I could be wrong about this, of course; I stated in the previous post that I was open to correction.  But multiple debt collection and bankruptcy attorneys in the previous comment threads confirmed my understanding.  The fact that the loans are large, and not bankruptable, seems to make it very difficult to get a settlement; the lenders would rather sue you, get a judgement, and then wait for you to get a paycheck or some assets they can garnish.  As I said, staying judgement proof for decades is likely to be much more miserable than repaying the debt.

Of course, you can and should negotiate somewhat--the question is whether you can negotiate them for less than you would have paid by not defaulting, or whether your "settlement" mostly consists of waiving some of the late fees, penalties, and excess interest that accrued while you weren't paying.  These can easily double the balance of your loan in a pretty short time, so it may look as if you're getting a fantastic 50% off deal, when in reality, you're still paying more than you would have paid if you'd just stayed current.  

Mystal was responding to a note from a law student who wanted to deal with his mounting loans by defaulting as soon as he left school, and then settling for 50 cents on the dollar; Mystal claimed that "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 seemed very unlikely to me that many people were going to be able to settle for 33% of their original principal, so I thought it was worth a warning.

Mystal has not explicitly confirmed that he has actually gotten an offer for such a settlement, so I don't know whether Mystal has gotten some very atypical offers from his collection agency, whether he's gotten an offer to settle for 33% of a badly inflated loan balance, or whether he has simply been assuming that he could negotiate these collection debts the way you negotiate credit card debts.  Or whether everything I've heard about private loan settlement is wrong.  But without some people leaping out of the woodwork to say "Yes, I've settled private student loans for less than the original principal", I would not recommend defaulting on the assumption that you'll be able to force lenders to give you a better deal.  

Let's walk through how this logic would work for a typical 26 year old single law grad. You save up 50% of your loan balance, default, and then go to your lender and say "I want to settle for fifty cents on the dollar."  Your lender has two options.  They can settle--or they can sue you, get a court order to empty your bank accounts, take the money, and then garnish your paychecks for the rest.  With other sorts of unsecured debt, they'd have to worry that you might use that wad of cash to buy a house and declare bankruptcy, but not with a student loan, because it's not bankruptable.  As long as they sue you within the statute of limitations, they have a decade or so during which they can slap a lien on your property or business, garnish your wages, and otherwise make your life really, really unpleasant.

There are some other considerations, which I touched on in the previous post, but which seem worth reiterating:

1)  Many private student loans require cosigners (mine did, though I wouldn't have asked if I'd known then what I know now). Whatever you think of the morality of voluntarily defaulting on the money you've borrowed, if you voluntarily default when there's a cosigner involved, you're really being grotesquely selfish.  This is someone close to you who put their credit on the line in order to help you get something you wanted, and you are repaying them by trashing their credit and exposing them to collection efforts, a potential lawsuit, and the seizure of any available assets to cover the deficiency.  

2) If you do secure a settlement, you will have to pay taxes on the forgiven loan balance, including the interest, unless it was tax deductible (for student loans, this means any interest in excess of $2500 a year--or all of it, if you made more than $75000).   Transforming private student loan debt into a debt to the IRS is unbelievably stupid--tax debt is also not bankruptable, and the IRS has very wide powers to get its money.

3)  You will trash your credit score for a long time.  This will not only make it difficult for you to get credit, but also to get some jobs.

4)  Being judgment proof is not, like, the worst thing in the entire world that could ever happen to anyone.  But it is also not fun, and if you really plan to not pay, you have to keep it up for more than a decade.  That means no bank accounts, no property upon which they can put a lien, no earnings above minimum wage that they can garnish, and no business worth putting a lien on.  The bigger the debt, the harder it is--credit card companies do not put a lot of effort into tracking down assets to cover your $1,000 unpaid balance, but a lender who is owed $100,000 is going to be pretty motivated to recover it.

It's easier if you have a spouse with decent credit and a fairly lucrative job.  But of course, if that person dies or leaves you, you then have to live on what you can make; any assets such as life insurance payouts or divorce settlements will of course be open to seizure.  And if you are single, you may find that prospective spouses are leery of people who regard their obligations as things to be discarded when they are inconvenient.  They may also be reluctant to sign on for the 15-20 years of self imposed poverty it is going to take you to stiff your creditors.

I am not denying that it's possible to settle your private student loans for pennies--I'm sure that someone, sometime has managed to do it.  I'm just saying that it's probably a stupid idea to default in the expectation that you'll be able to do so, which is what Mystal implied.

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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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