Should I Rehabilitate or Consolidate My Defaulted Federal Loans?

The situation for student loans has drastically changed due to the impact of the coronavirus pandemic, with the government temporarily suspending all federal student loan payments and interest charges, as well as stopping collection actions against defaulted loans. Visit the LendingTree Coronavirus Information Center for details.

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If your federal student loans are in default (meaning that you’ve missed 270 days of payments), you can take action in one of two ways: student loan rehabilitation or consolidation. Each option has its pros and cons, but either should help get your federal student loans out of default and allow you to avoid the stress of dealing with collections agents, wage garnishment and tax offsets.

If your federal student loans have fallen into default, here’s what you need to know about student loan rehabilitation vs. consolidation.

What are the consequences of federal student loan default?

The government has wide-reaching powers when it comes to collecting on debt, so defaulting on federal student loans could have major consequences.

• You will lose eligibility for forbearance or deferment.
• You could have your wages garnished or even face an offset on your taxes.
• Some older borrowers in student loan default have even been threatened with garnishment of their Social Security.
• Defaulted student loans will likely get reported to the major credit bureaus, meaning your credit score could take a serious hit. A damaged credit score takes time to build back up, and this could make it difficult to take out a mortgage or make other big financial moves in the future.
• Going into default could also mean your loans go to a collections agency. As a result, debt collectors might start calling asking for payment.

Note that this article focuses on the consequences for defaulting on federal student loans — the default process for private student loans is different. For one, private loans can go into default after just one missed payment, rather than having a 270-day buffer. Private loans also have a statute of limitations for default, whereas federal student loans do not.

3 options for getting out of default

The consequences of student loan default can be serious, so what can you do to get out of default? Here are three options:

1. Student loan rehabilitation

Student loan rehabilitation allows you to change federal student loans from their default status to current. If you have more than one student loan, you must apply to rehabilitate each separately. It’s important to know that you may only go through the rehabilitation process once over the lifetime of a loan.

In order to rehabilitate, you must:

• Have a Federal Direct, Family Education (FFEL) or Perkins Loan.
• Contact your lender to start the process; if you aren’t sure who your lender is, you can go here and select “view loan servicer details.”
• Agree in writing to make nine payments within 20 days of the due date and during a 10-month period if you have a Direct or Family Education Loan. For Perkins Loan repayments, the time period is nine months. Your payments under rehabilitation are expected to be reasonable based upon your financial situation and the number determined by the lender.

The loan servicer will request payments equal to 15% of your discretionary income, divided by 12. If you can’t afford those payments, you may ask your lender to recalculate the payment amount based on your documented income and expenses. It’s possible for borrowers in extreme financial distress to have rehabilitation payments as low as $5.

During the rehabilitation period, you may still have payments collected through garnishment of your wages or government payments. Rehabilitating your loan may also result in fees on the unpaid principal balance and accrued interest to the principal balance of the loan (the amount may vary, depending on factors like the collection agency and your state of residence). However, you may be able to get out of this if you enter into a satisfactory repayment agreement with your lender.

Benefits of student loan rehabilitation

• Once you’ve made your nine payments, your loan is considered rehabilitated and the default is removed from your credit history.
• You can rehabilitate loans that are already being paid through wage garnishment.
• Collection of payments through wage garnishment or Treasury offset will cease.
• You will regain eligibility for benefits lost when you were in default, including deferment, forbearance, a choice of repayment plans and loan forgiveness. That means you could make the necessary changes to your monthly payments to keep them affordable post-rehabilitation.
• You’ll be eligible once again to receive federal student aid.

Drawbacks of student loan rehabilitation

• While the default is removed after rehabilitation, your late payments from before you went into default will remain on your credit history.
• The process is relatively lengthy, as your loans are not considered fully rehabilitated until you’ve made the final payment.
• There may be fees involved, although these can be avoided.
• If you have multiple loans, you must rehabilitate each separately.

2. Student loan consolidation

Another option for a borrower with federal student loans in default is consolidation. With Direct Loan consolidation, your defaulted loans will be paid off, leaving you with a single, larger loan with one monthly payment, a fixed interest rate and, in most cases, a longer repayment term.

If you are looking into a Direct Consolidation Loan, here’s what you should know:

• Most federal loans are eligible for consolidation.
• You should have at least one other eligible student loan you can combine into one if you are consolidating a Direct Loan.
• You may reconsolidate a defaulted FFEL without including another loan, but only if you repay the new Direct Consolidation Loan through an income-driven repayment plan.
• You must make three consecutive monthly payments on your defaulted loan before you apply for consolidation, or you would have to pay the consolidated loan under an income-driven repayment plan.
• If you want to consolidate a defaulted loan that is already being garnished from your wages, or collected through a court order, you must ensure the garnishment order or judgment has been lifted.
• You must complete a Direct Consolidation Loan Application. You can go here to start the process.

Benefits of Direct Loan consolidation

• Once your loan is consolidated, you are out of default.
• Having just one loan payment can simplify your life.
• Your monthly bill may be lower because you will have a longer time to repay your loan.
• Consolidation may allow for access to additional income-driven, deferment, forbearance and loan forgiveness options.
• You can switch variable-rate loans to one fixed interest rate.
• Once you have consolidated your defaulted student loan, collections agents may no longer contact you.

Drawbacks of Direct Loan consolidation

• Your credit report will still include the information about your default for up to seven years.
• You may make more payments and pay more interest in the end, due to the longer repayment time period.
• Outstanding interest on the loans you consolidate becomes part of the new principal balance, which means you may be paying interest on a higher balance.
• You may lose certain borrower benefits, including interest rate discounts, principal rebates or loan cancellation benefits that are tied to your current loans.
• If you’re paying your current loans under an income-driven repayment plan, or if you’ve made payments toward a loan forgiveness program, you may lose credit for these payments made if you consolidate.

Loan Rehabilitation and Consolidation Comparison Chart

Source: Federal Student Aid

3. Pay off your student loans in full

A third option for getting your student loan out of default is to pay your loan off in full.

Providing a full payment will wipe out your debt and stop any consequences of default, such as wage garnishment or tax offsets, in their tracks.

Of course, this approach is probably not possible for most borrowers, especially not for those who end up in default in the first place, unless they have come into a financial windfall.

How to choose the best option for your finances

When it comes to choosing between rehabilitation and consolidation, keep in mind the pros and cons of each option, and consider your own unique situation. In the end, the key benefit is that both approaches accomplish your goal of getting your student loans out of default.

Remember as well that it is always best to avoid student loan default entirely if you can. There are several options available to you if you are having trouble managing your student loan payments, including deferment or forbearance, switching to an income-driven repayment plan and refinancing your loans.