Some student loan borrowers who find themselves in default on their federal or private student loans have the option to settle. If you meet the criteria, you could pay a lump sum that is less than what you actually owe. In return, the lender considers the debt paid off.

Is it worth the trouble? Student loan debt settlement often requires negotiation and comes with both pros and cons. Let's take a deeper look to see if settling your student loans makes sense for you:

Benefits of Student Loan Settlement

The most obvious benefit to settling your loans is paying off your loan. You won’t be required to make monthly payments and the debt will be eliminated. When you settle your student loans, you usually paying less than you owe, which means you save money over the long term, as interest is no longer accruing and compounding on your balance as you struggle to pay it down.

Defaulting on a student loan can wreak havoc on your credit, affecting everything from your ability to get credit cards and loans to your ability to rent an apartment. It could even affect your job prospects with certain employers — especially those that require a security clearance. If you're already in default, which most lenders will require before even considering settlement, them negotiating to settle your student loans will allow you to get out of default so you can start rebuilding your credit.

Risks of Student Loan Debt Settlement

Settling your student loan debt does come with risk. For one, settling actually can negatively impact your credit. While the debt will show as paid off, it will also show that you negotiated a settlement agreement. That tells future lenders that you failed to make regular, on-time payments.

Student loan debt settlement does, however, show that you’re taking steps to correct the problems and get back on the right track. But even with the student loan debt fully eliminated, lenders may think twice about offering you more credit. You will likely never be eligible for student loan refinancing, for example, if you have a history of a settlement on your debt.

The other risk is related to where the money is coming from to pay the settlement lump sum. If you dipped into your savings or cashed out your 401(k), for instance, you could be putting yourself into a riskier financial situation because you will be less prepared for emergencies. With retirement accounts, cashing out now will have an exponential effect on your available funds later because you will miss out on the benefit of compounding interest.

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Alternatives to Student Loan Debt Settlement

Aside from student loan debt settlement, you can explore other options to help you avoid defaults. If you have federal student loans, talk to your loan servicing company about payment arrangements or forbearance. You might be able to work out a new payment plan based on your income, or one that gives you a few months before you need to resume payments.

You could also look at a federal loan consolidation or rehabilitation. If you make nine out of 10 consecutive, voluntary, on-time, reasonable payments on a defaulted student loan, you can apply for loan rehabilitation. That removes the default from your credit and puts the loan back into good standing. In a consolidation, you need to make three consecutive, on-time payments to be eligible to have your loans consolidated.

If you have private student loans, first contact your lender. They may have programs or options that can help you get out of default. After all, the lender wants to get paid, and so they might be willing to work out a new payment arrangement or other option for you to consider if you cannot afford to settle your student loans. Then, you may want to contact a lawyer who specializes in student loan default. They may be able to offer you advice on how to proceed.

The Bottom Line

If you’re in default, your financial options are already limited because you have passed repayment plans and programs meant to help you stay out of default. If you can meet the criteria and negotiate to settle your student loan, and if you have a way to get the money to make that lump sum payment, you may want to weigh that option against the alternatives above.