This week I received an email from someone seeking advice on how to deal with her defaulted federal student loans. Specifically, she wanted to know if direct loan consolidation was a better option or if it was better to rehabilitate her loans. The reader name and email have not been included in this particular mailbag article do to the sensitivity of the situation.
When federal student loans are in default, the options are not particularly attractive. Both choices, rehabilitation and consolidation, have downsides. However, both options are far better than letting the loans stay in default. In fact, with late fees, compounding interest, and potentially court fees, being in default is very expensive. Because all federal loans have borrower protections like income-driven repayment plans and loan forgiveness, staying out of default in the future is manageable.
What is the difference between rehabilitating a loan and consolidating a defaulted loan?
Rehabilitation and consolidation both accomplish the same goal… getting a federal student loan or loans out of default.
In order to rehabilitate loans, borrowers must work with their loan servicers to get on a monthly payment plan. Rehabiliation requires the borrower to make nine payments in a ten month period to bring the loan out of default. This has to be done for each loan that is in default.
Consolidation requires the borrower to go through federal direct consolidation. Consolidating loans means that the old loans will be paid off in and a new larger consolidated loan will be created.
Which route is fastest?
Loan rehabilitation takes nearly a year and it is necessary for the borrower to work with each lender to bring all of their loans out of default.
Consolidation, by comparison, is a much faster process. Filling out the paperwork can be done very quickly. The Department of Education estimates that the online application only takes 30 minutes to complete. Once the application is submitted it typically takes the Department of Education people about 30 days to collect all of the necessary information so that all of the loans can get paid off. This process takes approximately 30 days. At that point the borrower receives notice fo the consolidation and the process is finalized. In total it can take a couple months, but little time an effort is required from the defaulted borrower.
Which approach will help credit scores more?
This is one area where rehabilitation gets a big edge. By rehabilitating loans, the notation on the credit report about the default will be removed. The late payments will still be on the report, so it doesn’t fix everything, but getting rid of the default is a big plus.
By consolidating the loans, the default will remain on the credit report for up to 7 years. As a result, going with the immediate consolidation route, does more damage to credit scores.
Are there fees to worry about?
This is one area that hurts regardless of the route selected. Consolidation can result in fees up to 18.5% while rehabilitation can result in fees up to 16%. However, the Department of Education at times will waif the 16% rehabilitation fee, so it is important for borrowers to ask about the potential savings.
When will the collectors go away?
The collectors stop as soon as the loans are consolidated or as soon as the rehabilitation process has been completed. Once the loans are brought out of default, borrowers should not be contacted again as long as the loans stay current.
Tips for staying out of Default
The best part about getting federal loans out of default is the many great federal repayment plans. Income based repayment plans, such as PAYE, ensure that even unemployed borrowers are able to keep their loans current.
Materials referenced and further reading:
The Student Loan Borrower Assistance Factsheet
NOLO information on consolidation and rehabilitation