Strategic Student Loan Default: How it Works

Strategic default is when you deliberately default on a loan — not making payments on your debt even though you could. Many borrowers try this “strategy” hoping to settle their loans for less than the total amount.

If you’re thinking of trying this idea, remember that it should be a last resort due to its serious, long-lasting consequences. Unless you can’t afford your monthly payment, have run out of deferment and forbearance, and can’t qualify for refinancing, you likely have better options.

I’ll explain why strategic default is rarely your best option and give 4 alternatives if you are struggling with student loans.

When you stop making payments on your student loans, you enter delinquency. As more time passes without paying, your loans will enter a stage known as default.

Once your student loan enters default, the entire balance becomes due. Your lender will also send your student loan to a collection agency, where additional fees begin to accrue.

When it comes to private student loan default, the ball is in the lender’s court. You’ll have to reference your promissory note for the details of your loan terms, such as when your loan enters default.

Typically, private student loans enter default as soon as payments reach 120 days past due, but the timeline for defaulting on private loans varies by lender.

Private student loan lenders can’t offset your IRS tax refunds, Social Security income, or other government payments. However, they can file a lawsuit in order to garnish your wages and gain access to your bank account.

Most federal student loans enter default after 270 days, or 9 months, of missing payments. Once they reach this point, the federal government is very good at getting its money back.

Federal student loan lenders won’t sell your loan to a collection agency. Instead, a debt collector will handle getting payment on your loans for a fee. The collection fee gets added to your loan amount, increasing how much you owe.

Additionally, the federal government doesn’t need to sue you to gain access to your income. If you default on a federal student loan, they can garnish your wages, offset your tax refunds, and more.

The most common reasons student loan borrowers consider strategic default are to discharge their loan through bankruptcy or to reach a settlement.

This is a flawed strategy because neither option is guaranteed. Your plan could backfire, leaving you with damaged credit and other significant consequences.

Does strategic default have anything to do with bankruptcy? Strategic default can sometimes be connected to bankruptcy. Some borrowers default on purpose, planning to file for bankruptcy and have their loans discharged. However, this isn’t a surefire strategy. Having your student loan discharged through either Chapter 7 or Chapter 13 bankruptcy isn’t promised.

Many bankruptcy courts require you to pass the Brunner Test to prove that making your student loan payments makes it impossible to maintain a quality standard of living. You also have to prove your situation won’t change any time soon.

Bankruptcy court can be costly due to legal fees and court costs, and there’s no certainty that bankruptcy will discharged the defaulted loans. What’s worse: in the meantime, your student loans are still accruing interest.

If your bankruptcy doesn’t cancel your student loans, you’ll be in worse shape than when you started.

Defaulting on your student loan to get a settlement offer is unwise. Your lender doesn’t have to offer you a settlement simply because you’re in default.

Instead, you could be faced with a court order requiring you to pay the total balance immediately. If that’s not an option, you could have your income garnished.

Additionally, the amount you settle for likely won’t offset the costs you incurred going into default. Every day your student loan has been accruing interest. Month after month, this unpaid interest snowballs into a large sum that’s added to your loan balance.

You’ll likely be charged a significant collection fee when the lender sends your loan to a collection agency. Reaching a settlement that offsets the additional costs of defaulting and the damage to your credit is highly unlikely.

Federal student loans generally don’t settle for less than 85% of the outstanding balance, leaving you on the hook for most of your loan amount along with other potential fees. After these fees, you may owe more than before you “strategically” defaulted.

Aside from the questionable economics and ethics involved, strategic defaulters can face seriously negative impacts if they walk away from their student loans.

What are the consequences of strategic default? The consequences of strategic default include:

• Damaged credit. Regardless of your outcome, your credit score will drop from the missed payments. Bad credit will make it difficult to get a credit card, force you to pay high interest rates, and need a higher down payment to get approved for loans.

• Increased loan balance. Your accrued interest and collection fees can cause your loan amount to balloon.

• Ineligibility for other student loan features. When you default on a student loan, you will lose eligibility for forbearance, deferment, loan forgiveness programs, and other loan modifications.

• Lost income. If your defaulted loans are owned by the government, they can collect on unpaid loans through wage garnishment, tax refund offsets, or Social Security income offsets.

• Trouble getting a mortgage. This could make it more challenging to buy a home.

Remember that strategic default isn’t a guarantee that you will reach a settlement or save money. Your lender doesn’t have to accept a settlement offer simply because you’re in default. Bottom line: strategic defaults aren’t worth the risks involved.

Defaulting on a student loan can be much more expensive than keeping up with your monthly payments due to the additional fees.

As soon as you start missing payments, monthly interest begins to be added to your loan balance. The following month, interest is calculated on the principal balance plus the previous month’s interest. Over time, this amount begins to snowball.

Once you default on a student loan, your lender will send your loan off to a collection agency, which will charge a collection fee of up to 25% of the loan balance, potentially costing you thousands of dollars.

On top of this collection fee, your interest is still building up. Plus, interest capitalization can leave you paying interest on top of your interest. The last thing you want is more to pay back!

If you’re struggling to make your student loan payments, there are many options better than strategic default. Whether your loans are public or private, these alternatives get better results than ignoring your payments.

Deferment or forbearance

Both deferment and forbearance allow you to put a pause on your student loan payments, so long as you’re not in default. You’ll keep your good credit and avoid delinquency. Forbearance still accrues interest, as does deferment for unsubsidized federal loans.

However, with subsidized federal loans, no interest will accrue while payments are paused. While many private student loan lenders offer deferment while you’re in school or active military duty, not all of them will offer forbearance.

You may want to talk to a student loan lawyer about which of these options apply to you. Even if interest continues to accrue on your loan, having a break to regroup and rebuild your finances can be helpful.

Income-driven repayment

Federal loans can offer repayment plans based on how much you make. By supplying your income information, you can get a payment plan tailored to your financial situation. If you can’t make your current payments, this can be an excellent way to find relief without defaulting.

Unfortunately, private student loans don’t usually offer income-based repayment options or many other flexible payment plans.

Consolidation

If you’re finding it difficult managing several different student loans all at once, a consolidation or refinance loan can combine your loans, making them easier to manage. This is an option available to both federal and private borrowers.

For defaulted federal student loans, a Direct Consolidation Loan can get your student loan back in good standing within 2-3 months.

To qualify, you’ll need to make 3 consecutive, on-time monthly payments or agree to repay the new consolidation loan under an income-driven repayment plan.

Rehabilitation

This route is reserved for federal student loans that are in default. Student loan rehabilitation can help repair some of the damage to your credit by removing the default from your credit report.

Your defaulted student loan will be in good standing after you’ve made 9 payments during a period of 10 consecutive months. Just remember, this option is only available once, so make it count!

Another common form of strategic default is in real estate. Some homeowners default through strategic foreclosure or mortgage default. This is when homeowners quit making their mortgage payments and default on their home loans, believing them to be a bad investment.

This was fairly common during the financial crisis in 2008. Home prices dropped significantly, causing homeowners to be upside down or owe more than their home values. The entire housing market diminished, and almost every homeowner had negative equity.

Rather than refinancing or choosing a short sale, borrowers chose a deed-in-lieu of foreclosure that transferred the title of the home to the mortgage lender, hoping to relieve themselves of the mortgage debt.

This led to the term “jingle mail” because the keys would often be attached to the deed. Because of the underwater mortgages, many homeowners were hit with deficiency judgments for the difference between the mortgage balance and the foreclosure sale price.

Regardless of real estate or student loans, a strategic default is a risky move that can leave you in dire financial straits.

When it comes to working with student loan borrowers, I’ve seen it all. I know you have better options than choosing to default on your student loans.

Let’s talk. Let’s look at your situation realistically and create a plan that will provide you with results. Schedule a call with me today and take the first time in getting your life back.