June 9, 2009 in Student Loans

The jobless economy is taking a toll on a growing number of college grads who are behind on their student loans. Nearly 7 percent of student loans for fiscal year 2007 are expected to default, involving more than 231,000 borrowers, according to the U.S. Department of Education.

Avoid default on student loans

  • Let the lender know.
  • Ask about payment plans.
  • Investigate payment postponement options.
  • Research loan cancellation and forgiveness.
  • Dig out of default.

Default is the worst outcome, resulting in a blemished credit score at least, as well as garnished wages and possibly getting sued for the full loan amount. Fortunately, grads facing economic troubles have much better options. Here’s what to do if your dollars won’t cover your student loan debt.

Let the lender know

“Students who are in trouble absolutely have to talk with their lender first,” says Michael Gaer, creator of Collegefinancing.com and president of Gaer Financial Group, based in Hackensack, N.J. “They can’t just walk away from it because it’s going to affect their credit score. It’s going to affect their entire lives.”

Gaer says that students who apply the silent treatment to their creditors will immediately fall into delinquency and later into default, usually after missing two to three payments.

Those who tell their lenders upfront that paying is difficult will have an array of options, especially with federal loans. While each private lender has its own rules and punitive measures for borrowers, those who disburse federal loans are required to offer borrowers deferment options and the ability to change their payment plans once a year.

MORE: What is a student loan deferment?

Ask about payment plans

A simple way to lower your monthly payments without hurting your credit score is to change payment plans, says Sam Wilson of Texas Guaranteed Student Loan Corp., a nonprofit student loan disbursement agency.

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“Ten years is the standard repayment period on a student loan,” says Wilson. “But that doesn’t mean that they have to make equal payments every month for all 10 years. Most students don’t know that there are several payment plan options.”

The federal government currently offers four basic types of repayment plans.

Current repayment plans

  • The standard plan lets students pay the same fixed amount each month ($50 per month minimum).
  • An extended plan stretches payments across 12 years to 25 years (available only for borrowers with loans totaling more than $30,000).
  • A graduated plan requires lower payments in the first few years, and then the payments are increased every two years until the loan term is up.
  • An income-contingent plan assigns payment amounts based on a percentage of the graduate’s annual income (anywhere from 4 percent to 25 percent).

If a borrower who opts for the last payment option never earns enough to fully repay the loan, whatever principal that is left after 25 years’ worth of payments is forgiven.

The feds will roll out a fifth option starting July 1 — the income-based repayment plan.

Income-based repayment caps monthly payments at 15 percent of a borrower’s discretionary income, says Patricia Nash Christel, spokeswoman for Sallie Mae. This is defined as any earnings above 150 percent of the poverty line, she says.

Currently, the poverty level for a single person is about $11,000, she says. So at 150 percent, the income floor is about $16,000. “That would mean that payments would be 15 percent of any income over $16,000,” she says.

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In this case, Christel says that individual borrowers who earn $16,000 or less per year will have no payments until they start earning more.

Like the income-contingent plan, the income-based repayment option requires grads to make regular payments (excluding deferment and forbearance periods) for 25 years, after which any leftover principal is canceled.

A final option is to opt for a temporary interest-only repayment plan. Unlike the aforementioned repayment options, interest-only plans are available only for a specific amount of time to be negotiated between borrower and lender.

Investigate payment postponement options

A borrower who can’t make payments at all has a few options, provided the lender is notified before the loan goes into default, says Kimberly Carter, manager of repayment assistance for American Student Assistance, a nonprofit student loan guarantor agency that provides debt management services and insures private lenders against the risk of default on college loans.

“Everyone in the federal loan program who can prove that they have financial hardship is entitled to a deferment, provided that they meet eligibility requirements,” says Carter. “In deferment, payments are postponed for up to a year. And if you have a subsidized loan, the government will pay the interest for that time.”

According to the Department of Education, the most common reasons for deferment are inability to find full-time employment, economic hardship and military duty.

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Depending on the type the borrower seeks, the deferment may be renewed for up to three years without affecting the borrower’s credit score. A student seeking deferment must provide documentation of economic hardship for each year in the deferment period.

Borrowers with private loans and those who don’t qualify for federal loan deferments can request a forbearance, says Wilson.

“A forbearance is an agreement between the lender and the student that suspends payments for up to a year,” he says. “During the forbearance period, the interest is capitalized, which means it’s added back into the loan balance. People who use forbearance will see their balance grow.”

The difference between deferment and forbearance is that while federal loan borrowers are entitled to a deferment, a forbearance is at a lender’s discretion, Wilson says. For federal loans, students can apply for forbearances each year for up to three years and must provide documentation. For private loans, documentation requirements and forbearance lengths vary from lender to lender.

Like the income-contingent plan, the income-based repayment option requires grads to make regular payments (excluding deferment and forbearance periods) for 25 years, after which any leftover principal is canceled.

A final option is to opt for a temporary interest-only repayment plan. Unlike the aforementioned repayment options, interest-only plans are available only for a specific amount of time to be negotiated between borrower and lender.

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Research loan cancellation and forgiveness

Borrowers who have exhausted their deferment, forbearance and repayment plan options can seek loan cancellation and forgiveness options if they qualify.

Borrowers in service positions such as teaching, nursing, the military and public defense could get their loans canceled through federal or state-sponsored programs. Although a few states, such as Kentucky, California and Iowa, have either severely reduced or eliminated their loan forgiveness programs in certain fields, many states will still forgive up to four years of the total cost of college for students who meet eligibility requirements.

Loan forgiveness is also available through national organizations such as the National Health Service Corps and The American Occupational Therapy Association.

While loan forgiveness eligibility requirements for national organizations vary, those in public service positions seeking loan forgiveness through the federal government must first make 120 payments on their loans, starting after Oct. 1, 2007. As long as borrowers stay in their given field, Uncle Sam will forgive any debt after those payments.

Borrowers who aren’t in service fields can have up to 70 percent of their loans canceled by serving in the Peace Corps, Americorps or Teach For America. Borrowers who take this route won’t have to make any payments before receiving loan forgiveness.

Borrowers who suffer extreme circumstances, such as permanent disability, could get their loans canceled through bankruptcy, but this route requires substantial documentation and works in very few cases.

Dig out of default

“(Federal loan) borrowers that have already defaulted need to call their lender and ask about rehabilitation programs,” says Carter. While American Student Assistance and other organizations have shut down their loan rehabilitation programs because of the current economic downturn, a few still allow federal borrowers to get out of default by making nine or 10 consecutive loan payments.

Christen says that organizations that don’t currently offer rehabilitation options may be able to work with defaulted borrowers to create a customized payment plan.

“In this environment, lenders want to work with you to make sure you’re successful,” she says. “Nobody wins if someone defaults.”

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