Can You Settle Student Loan Debt?

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Student loans can take a serious toll on your finances—a reality that many Americans grapple with daily. There are 42.9 million student borrowers in debt, according to 2020 data from the National Student Loan Data System. And in 2019, graduating students of public and private nonprofit colleges left university owing an average of $28,950 in student loans.

If you have student loans, you may wonder whether it’s possible to settle student loan debt. While doing so is not impossible, it is very difficult. Below, we’ll discuss situations in which you can settle student loans, how student loan settlement works, and alternative options you may want to consider. 

When Can You Settle Student Loan Debt?

If you have a large sum of student loan debt, you may be able to settle it. The Department of Education can settle certain loans of any amount, and also suspend or terminate the collection process of these loans, depending on the circumstances. If your lender agrees to it, though, the negotiation process can be challenging. 

Lenders will usually require that you default on your student loans before you settle them. Your loans are considered in default if “you’re 270 days past due on your federal student loan payments, or 120 days past due on your private student loan payments,” said Katie Ross, education and development manager at nonprofit American Consumer Credit Counseling. 

When You Shouldn’t Settle Student Loan Debt

If you have federal loans that qualify for forgiveness or discharge, settling them might not be the best move, according to Saki Kurose, associate planner at Insight Financial Strategists. Forgiveness or discharge can allow you to pay very little or nothing at all.

If you’re able to make your student loan debt payments, you should continue to do so to protect your credit. While paying off a student loan provides long-term benefits that outweigh the potential impact to your credit score, it’s still important to ensure it stays in the normal range.

How Student Loan Settlement Works

When trying to settle debt, you will make an agreement with your lender on the amount you’re willing to pay. You can either work with a debt settlement company that will negotiate on your behalf, or go through the process on your own and attempt to settle directly with your lender. Generally, the process of debt settlement works as follows:

  • You don’t pay on your loans for several months. 
  • Then, those loans go into default. 
  • Once they’re in default, lenders will negotiate the settlement. 

“If your loans are in default and you have a big amount of cash saved up, your lender might be willing to settle,” Justin Nabity, CFP and founder of Physicians Thrive, told The Balance. “While some lenders might be willing to settle 50% of your loan, others may require somewhere around 90% of it.”

If you pursue student loan settlement using this strategy, there’s no guarantee that lenders will agree to settle your debt. Also, there’s a chance that they’ll garnish your wages or even sue you, so proceed with caution and weigh all of the factors when considering student loan settlement.

Credit Score Implications

Since you won’t make payments on your loans for several months, debt settlement can have a negative impact on your credit score. This is because payment history is one of the most important factors that determines your credit score, and you won’t be paying a balance in full. A poor credit score can make it a challenge for you to get approved for a car loan, personal loan, credit card, or other products in the future. However, credit is based on various factors, so the impact on your credit score will vary from person to person, depending on other information on the credit report.

Tax Implications

In the event lenders agree to settle some or all of your debt, you’ll be on the hook for taxes. The debt that they forgive when you settle will be counted as income by the IRS and taxed. Depending on how much you settle, this may significantly increase your tax bill. 

Debt is considered canceled if it is forgiven or discharged for less than the full amount you initially owed. And in general, canceled debt is considered income, so the amount of the canceled debt is taxable and must be reported on your tax return for the year in which the cancellation occurs. 

Alternatives to Student Loan Settlement

If you’re unable to settle your student loan debt, consider these alternatives.

  • Student loan discharge: There are several cases where your student loans may get discharged. Your loans qualify if the college you’re attending is closed, you suffer from a total and permanent disability, or your school did something wrong, like mislead you about its qualification. 
  • Income-driven repayment plan: With an income-driven repayment plan, your student loan payments can be adjusted based on how much money you earn. If your income is low enough, your payments could drop to zero.
  • Refinancing: You can refinance your student loan debt to a better interest rate. If your current rate is 6%, for instance, and you refinance down to 3%, you’d cut your interest payments in half. The downside, though, is that you may lose payment flexibility and other benefits that were available when working with the government. 
  • Public service forgiveness: Public Service Forgiveness may be an option if you work for a public employer like a government agency or nonprofit organization. With this program, your loans may be forgiven after you’ve made 120 eligible payments. However, eligibility for this option is low, with just 2.4% applicants being accepted in 2020.  

For more guidance, you can reach out to a nonprofit credit counseling agency and ask them to go through your budget with you. They may help you come up with a game plan and the best options moving forward.