New plan on student-loan defaults eases repayment

I VOLUNTEER at a correctional institution for women. During one financial-literacy class, I was struck by something that was disturbing two inmates who were scheduled to be released within the next two years.

They were worried about defaulted student loans. Once out of prison, they feared that if they found a job, debt collectors would come after their paychecks. They were concerned that late fees, additional interest and other collection costs would make it impossible for them to get out of default.

They knew, like so many others who have defaulted, that student loans really never go away. Having them is like being in a debtor's prison.

But there is hope for those who think they have fallen hopelessly behind. As of July 1, borrowers in default have to be offered a standardized payment option to rehabilitate their defaulted loans.

Default has serious financial consequences. You can lose eligibility for deferment, forbearance and access to more affordable repayment plans. The government can snatch your federal and state tax refunds. And a default can severely damage your credit rating. A default occurs when you fail to make a payment for 270 days.

Under new U.S. Department of Education rules, a borrower can qualify to rehabilitate defaulted federal loans by making nine voluntary on-time, full monthly payments over 10 consecutive months. (The extra month allows a borrower to be late on a payment and still qualify.)

Loan rehabilitation was supposed to be "reasonable and affordable" based on a borrower's financial circumstances. Except there was no clear definition of what reasonable and affordable meant. Payments varied among lenders. In some cases, those payments were calculated based on a percentage of the outstanding loan balance, typically 1 percent. As a result, many borrowers complained that their rehabilitation payments were unreasonable and unaffordable.

"The change is intended to make sure everyone is treated the same way," said Betsy Mayotte, director of regulatory compliance for American Student Assistance, a nonprofit that aims to help people manage and repay their college loans. "A default rehab was supposed to be based on people's financial circumstance rather than their balances."

Under the new rule, the rehab formula is based on the one used for the federal Income-Based Repayment program, or IBR. This plan allows borrowers to have their monthly payments based on their income, family size and state of residence - 15 percent of adjusted gross income that exceeds 150 percent of the federal poverty guideline. American Student Assistance has a calculator on its website (ph.ly/Calc).

Using the 15 percent formula, let's say a borrower and spouse have an adjusted annual income of $35,000. The monthly rehab payment would be about $143. But that same borrower in a family of four would pay just $5.

Keep in mind you'll have to figure out how to make your regular payments after you get out of rehab. Also, while the calculation is similar to the one used under IBR, you'll still need to apply for IBR or another payment option if you still need a lower payment amount once you rehabilitate your loan, Mayotte pointed out.

If you apply for rehabilitation and find that the payment is too high, you can fill out a form to have the loan holder consider an even lower payment by considering in more detail your income and expenses.

If you are being forced to make payments because of a wage garnishment, such payments do not count toward your rehabilitation payments. However, an order can be suspended if you make the first five voluntary payments under rehab, Mayotte said. It's also possible that the loan holder may adjust the garnishment amount to help make the voluntary payments manageable, she said.

"It stands to reason that a lot of people didn't try to get out of default because they didn't know what to expect," Mayotte said.

Regarding the soon-to-be-released inmates, Mayotte suggested that they resolve the defaulted loans right away - either through rehab or consolidation.

"I would hate to see them obtain employment, only for the new employer to receive a garnishment order," she said. "If they resolve the default before obtaining employment, they can apply for an unemployment deferment or economic hardship or even income-based repayment."

If you've been scared to deal with your defaulted loan, now's the time to face your fear.