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Recovering from defaulting on your student loan

Once you default on a federal student loan by failing to pay for 270 days, things can get awfully bleak awfully fast.

Your wages could be garnished. You could be sued. Your federal and state tax refunds could be seized. And your already banged-up credit rating will take a real nose dive.

With a default on your credit record, you'll have an awfully tough time qualifying for a mortgage or auto loan or even a credit card.

"Some but not all lending institutions will look at a student loan default as worse than a bankruptcy," says Betsy Mayotte, manager of regulatory compliance at American Student Assistance. "It's a very serious black mark on your credit."

You'll also have some very serious collection costs to pay -- as much as 25 percent of the defaulted loan balance. And through it all the collection calls and letters will keep coming and coming.

"The federal government can be expected to collect on a student loan for at least 25 years," says Dana Callihan, vice president of external relations for EdFund.

Cleaning up your default mess
It may feel like there's no way back from a defaulted loan, but there is. It's possible to rehab your credit and get that default wiped off your credit record for good.

Rehabilitating a defaulted student loan won't be quick or easy, but it's the best way to get your life and your credit back on track.

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To rehabilitate a loan, you need to make nine to 12 consecutive, on-time monthly payments. The loan is then sold to a new lender, and the default gets wiped off your credit record.

"A lender buys back a defaulted loan so it's like it never happened," Sue McMillin, senior vice president for customer relations and business operations at Texas Guaranteed.

After rehab, you're left with a new loan in good standing, and your credit record is cleaned of the default. But smaller bruises on your credit will stay. Black marks for missed payments prior to the loan's default remain on your credit record for seven years.

By rehabbing your default loan, you also regain all the rights and payment options of federal student loan borrowers. For example, your loan payments could be deferred if you're unemployed or you decide to go back to college.

You also have the options of choosing an extended, graduated or income-sensitive repayment plan on your new loan. With an extended payment plan, you make minimum payments of at least $50, but you can take up to 30 years to repay the loan. With a graduated repayment plan, your payments start out low and then increase, typically every two years.

With an income-contingent repayment plan, your monthly payments are adjusted each year based on your income and loan debt. Calculators on FinAid site let you compare monthly loan payments on each type of repayment plan.

The loan consolidation and return-to-school options
Another repair option for folks with a defaulted loan is loan consolidation. To qualify for a loan consolidation, you'll need to make up to three months of consecutive on-time payments. Once you make the required payments, you can obtain a federal consolidation loan just like any other borrower.

With a federal consolidation loan, your lender pays off the balances of all the loans you choose to consolidate and then issues you a new loan. A consolidation loan can lower a borrower's monthly loan payments by as much as 40 percent and stretch out the repayment period.

Once you consolidate your loan, your credit report will be updated to reflect that your defaulted loan is paid in full via consolidation. The original default notation stays on your credit report for seven years.

"It's an improvement but it's not a complete clean up of a borrower's credit," says Bob Murray, a spokesman for USA Funds, the nation's largest education loan guarantor.

Defaulted borrowers who want to boost their credit in a hurry -- often so they can qualify for a mortgage -- tend to choose consolidation.

"Literally within a three- to six-month period you can get your credit picked up pretty quickly," McMillin says.

A defaulted borrower whose top priority is returning to school has another option to consider. By making six consecutive on-time payments, you can re-establish your eligibility for federal financial aid. That way, you'll be able to use federal loans to help pay for any future education plans.

But you'll still have to make monthly payments on the defaulted loan while you attend classes. To be eligible for deferment on a defaulted loan, you must either rehabilitate the loan or consolidate it.

The pay-off option
The final option for a defaulted borrower is to pay off the loan amount in full. The defaulted loan will remain on your credit report, but it will be updated to show that the loan has been paid in full.

Of course, most defaulted borrowers can't afford to do that. But it's important to do something.

The longer you wait, the bigger your defaulted loan balance will grow. Paying something, no matter how small, is better than paying nothing. And the collection letters and calls won't stop until you pay.

So call your guarantor or its collection agency, explain your current financial situation and ask about repayment options.

"The biggest mistake I see student loan borrowers make is not making the phone call," Mayotte says.

"Just make the call. We're not the big, bad collection agency that's going to threaten their mother. We want to help them."

Making the call is good advice for any student-loan borrower who is struggling to pay or falling behind on loan payments. Talk to your lender. You may qualify for forbearance or deferment, but you'll never know if you don't make the call.

"Whether it's 30 days delinquent or 180 days delinquent, they need to get on the phone with their lender and figure out what their options are," Callihan says. "The best option is to stay out of default."

-- Posted: March 18, 2003
Read more stories by Lucy  Lazarony
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Grads can cash in on consolidation
Comparing college-saving plans
Financial advice glossary
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