Student Loan Debt Settlement and Your Credit Score

Student loan debt settlement, like all forms of debt settlement, will cause an initial drop in your credit score. This is the penalty provided by lenders because they lost money on the loan. However, your credit may recover faster or slower depending on the type of debt you had and how you decide to handle the settlement.

Initial Credit Penalties

The lender will initially report you to the credit bureaus for settling the debt instead of paying it in full. This means two things. First, your score will drop as a result of a negative report. Second, the debt will reflect an unsatisfactory closing on your permanent credit score. This negative information could be removed from your score within five years, but the length of time differs from state-to-state. It is possible your settlement will remain on record for up to 15 years. This has a much more lasting effect on your credit than the initial drop in your score. Future lenders will see you settled the debt, and they will see you as a settlement risk in the future. They will be less likely to extend you flexible loan terms as a result.

Consolidation Penalties

Settling only one student debt will minimize the effect of this punishment. Settling multiple debts, though, will exacerbate the effect. Many student borrowers enter consolidation programs. These programs take all of the debts incurred, including living expense debts, credit card debts and tuition debts, and lump them together into one. During the process, the consolidation lender settles all of the loans. The result is one manageable loan that is lower than the sum of the debts that were once remaining. However, the penalty for this option is high enough to make it unattractive for most borrowers who are not facing severe debt situations.

Ongoing Credit Recovery

Recovering from student loan debt settlement can be a short process or a very long one depending on how you handled the settlement. If you paid off your debt with your own cash, perhaps through the signing bonus you received at your first job or through an inheritance, you will no longer have any debt on record. This makes for a faster recovery. Similarly, if you elected a settlement loan with recovery in mind, you may see your score rise faster. This means picking a loan with a short maturity date, unsecured with collateral and without a cosigner. Of course, this type of loan will be expensive in the short run, so it is not an option for all borrowers.

Penalties on Federal Student Loan Debt

If you prepay federal student loan debt, there is never a penalty. However, the same is not true if you settle the debt. In fact, most federal student loans cannot be settled for less than the remaining sum on the loan. They can be consolidated, refinanced and prepaid, but they cannot be closed unless you have met the legal obligations you have to pay the debts. The main exception is student loan forgiveness, but this is only an option for a small group of borrowers.