Imagine this scenario: You’ve been out of college for several years, have a good job and you have no problems making your student loan payments in full and on time. Then tragedy hits; your parent dies or declares bankruptcy. If this loved one was a co-signer on your student loan, this change can trigger an often-overlooked clause that allows the lender to claim you are in default on your loan, potentially wreaking longterm havoc on your credit and finances.
With tuition rates outpacing inflation, a growing number of students have had to turn to student loans. Borrowers also increasingly took out private loans to make up difference that federal loans won’t cover. In order to obtain these loans or to minimize the interest rates, many private loans are co-signed by parents or other family members.
According to the Consumer Financial Protection Bureau, whose April 2014 report listed auto-defaults as a significant source of complaints from borrowers, nearly 90% of private student loans were co-signed in 2011.
So, how does an option intended to help student borrowers with no or poor credit histories turn into a credit-wrecker?
What The #*&(@ Is An Automatic Default?Image courtesy of bluwmongoose
If you have a private student loan, you may not know that buried deep within the terms of that loan there may be a small but poisonous provision that permits the lender or loan servicer to place a loan in default, or accelerate the full balance of the loan, upon the death or bankruptcy of a co-signer. And it doesn’t matter whether the loan is in good standing or if you are financially stable.
Deanne Loonin, director of the National Consumer Law Center’s Student Loan Borrower Assistance Project, tells Consumerist that her organization has been trying to spotlight this hazard to borrowers.
“There’s no standard language required so there are variations on the theme,” explains Loonin, “but that’s where it originates.”
The Student Loan Borrower Assistance Project offers examples of what these kinds of provisions may look like.
How Do Lenders Decide To Default?
They are called “automatic defaults,” but how automated are the systems that determine whether or not your loan is suddenly due?
Because each lender is different in the way it handles auto-defaults, there is no hard-and-fast answer to that question.
According to the CFPB report, some industry participants rely on third parties that scan public records of death and bankruptcy filings. Those records are then electronically matched to customer records and used to trigger the default. Lenders who rely on this process often do not take into any extenuating circumstances into consideration before hitting the default button.
That isn’t always the case, explains the CFPB’s Rohit Chopra (who previously answered a bunch of Consumerist readers’ student loan questions).
Banks that actually own the loans they service are generally able to exercise more discretion on defaults, explains Chopra. But even that leeway is subject to pooling and servicing agreements, which lay out rules that govern bundled securitized loans and can often be restrictive.
Bad for the Banks
While the auto-default rules are intended to protect lenders from being stiffed by a borrower who can’t repay without a co-signer, Chopra explains that these provisions can lead to outcomes that are not in the best interest of the financial institution or the borrower.
“For many lenders, they might find that it doesn’t make sense to demand a full balance on a loan when a person is paying on time and has been for a significant period of years,” Chopra says of automatic default clauses.
4 Ways Auto-Defaults Can Backfire On Banks
Reduction of Interest Income: Placing a loan that is in good-standing in default and demanding the full balance will likely reduce the interest income over the life of the loan.
Reduced Recovery of Principal: Automatic defaults may lead to lower recoveries of principal balances because a borrower is unlikely to be able to cover the entire cost of the loan immediately; additionally, the servicer could lose money by using collection agencies.
Poor Customer Experience: For a borrower who has proven to be a responsible paying customer and is facing the death of a parent or grandparent co-signer, debt collection calls demanding the full balance with limited explanation will probably not be welcomed. This might substantially reduce the willingness of the borrower to pursue other credit products with the financial institution.
Damage to Reputation: The deployment of debt collection protocols on an otherwise-performing loan in a time of a family tragedy may give the impression that a private student lender or servicer is inadequately managed or simply unwilling to work constructively with borrowers.
Damage That Can’t Be Undone?Image courtesy of Tim Schreier
While auto-defaults may look bad for banks, the consequences for borrowers are much worse and longer-lasting, even though the borrower may have done nothing to cause the problem.
Student loan servicers report automatic defaults to credit bureaus, negatively impacting the borrower’s credit profile, which, in turn, makes it challenging to qualify for future loans, obtain credit, or even get a job.
Loonin explains that credit reports don’t make a distinction about the reason for a default, meaning most loans placed in default are treated the same way.
Stopping The Problem Before It Starts
Federal loans generally don’t require a co-signer, but a number of students who take out private loans do so without first exhausting all federal lending options.
“Private student loans should really be a last resort, if possible,” says Chopra. “When you run into trouble you often have very few options to navigate tough times.”
Of course, with tuition rates still on the rise, federal loans won’t provide enough funding for some students, leaving private student loans as the only option.
“With private student loans, because it’s so much money, consumers need to look at terms very carefully before signing the contract,” Maura Dundon, senior policy counsel with the Center For Responsible Lending, tells Consumerist. “You need to check for these provisions.”
One of the main issues with these types of loans, and their provisions, is that the consumers taking them out are young and simply not looking to the future.
“While you don’t expect to hit tough times, consider the class of 2008,” Chopra says. “They started school when the economy was okay, but by the time they graduated, it began to crater.”
What If I Already Have One Of These Loans?
There may be an out for consumers that have already taken out private loans with auto-default provisions, but it all depends on the wording in your contract.
For example, if you’ve been out of college for five years and no longer see the need to have your parent tethered to your existing loan, some lenders will offer a co-signer release if a borrower meets certain requirements – generally a set number of on-time payments.
But Chopra explains that many borrowers have found that their loan contracts don’t include co-signer release provisions, meaning they may be stuck.
And even those borrowers who do have co-signer release provisions have learned that actually obtaining that release is no simple task.
In one case highlighted in the CFPB report, a borrower reported that at the time of origination, the lender stated it could release his co-signer after he made 28 on-time payments. However after making those payments, the borrower learned that 36 payments were required. After making the additional payments, he was told that 48 payments were now required.
Dundon suggests to avoid this situation, borrowers working toward completing requirements set by the release guidelines should keep thorough records and stay in touch with the lender.
According to Chopra, many borrowers who try to learn their lender’s co-signer release guidelines — and all the attendant paperwork — often run into roadblocks, like being unable to locate any of this information on lenders’ and servicers’ websites.
But that doesn’t mean a borrower is out of luck entirely.
Chopra tells Consumerist that the letters have been very helpful for borrowers so far.
What If There Is No Co-Signer Release Provision?
Consumers that do not have co-signer release provisions, or who are finding out too late that their loan contains this auto-default clause, may not be completely screwed.
Because triggering automatic defaults isn’t the best business practice for banking institutions, borrowers can try to appeal to their servicer.
“It’s a case-by-case basis and depends on how long the default has lasted,” Loonin says. “You can try to work with the lender on a payment plan.”
However, most lenders write off loans after about 120 days, so some borrowers might need to work with a debt collector or company other than their original lender.
This Is All Going To Change, Right?Image courtesy of John Hanley
Following the CFPB’s report on automatic default clauses and their potentially devastating after-effects, legislators began taking a look at what could be done to protect consumers.
In early May, New York Representative Tim Bishop proposed an amendment to the Truth in Lending Act that would establish requirements for the treatment of a private education loans upon the death or bankruptcy of a co-signer of a loan.
Known as the Protecting Students From Automatic Default Act of 2014, the proposed amendment adds a section to the current Act that outlines duties a servicer should follow upon learning of a co-signer’s death or bankruptcy. The law would require the lender to immediately notify the borrower if an auto-default is going to be triggered, or if the loss of the co-signer otherwise changes the terms of the loan, or accelerates the repayment terms of the loan.
Additionally, the proposed bill establishes a timeline of at least 90 days for the borrower to identify a new co-signer, if necessary, before facing default.
While the bill has yet to make any progress, its introduction is just one sign that things could change for the better.
So Long Sallie?
I change that would have a more immediate effect if it comes to pass, Sallie Mae, the issuer of millions of student loans may be getting out of the business of automatic defaults.
A spokesperson for the company tells Consumerist that shortly before spinning off its loan servicing operation into a separate entity called Navient Corporation, Sallie Mae revised its policy on the position of removing deceased co-signers from private education loans.
Sallie Mae’s process upon notification of a co-signer’s death now calls for the customer to automatically continue as the sole individual on the loan with the same terms.
Additionally, if the customer’s account becomes delinquent, the company will work with him or her to understand his or her ability to make ongoing payments.
The company reserves the right to modify the loan’s terms to accommodate the customer’s demonstrated ability to pay if the customer is in financial hardship.
“We deeply regret that prior contacts made on our behalf to family members of a deceased cosigner may have been unintentionally insensitive and caused unnecessary burdens at such difficult times,” the spokesperson said.
The company is also prospectively removing co-signer death from its promissory notes as a basis on which Smart Option Student Loans may be placed in default.
So while these automatic default clauses can wreak-havoc, not all hope is lost just yet.