Making Rehabilitation a True Borrower Benefit

A few weeks ago, we wrote about how the financial crisis had gummed up the federal student loan rehabilitation process, leaving thousands of borrowers stuck in default. We are pleased that the U.S. House of Representatives recently tackled this issue as part of its technical amendments to the Higher Education Act reauthorization legislation Congress passed last year, and especially heartened that it did not turn the rehabilitation fix into a boon for guaranty agencies. But as we wait for the Senate to consider its own version of the legislation, lawmakers need to ensure that the final bill includes important changes the House made that would finally turn the rehabilitation process into a true benefit for borrowers.

Loan rehabilitation is designed as a one-time way for borrowers who have defaulted on their federal student loans to return their debt to regular repayment status. Successful rehabilitation requires borrowers to work with their guaranty agency — the entity that takes control of the loan once a lender files a default claim — to establish a new payment plan. Borrowers are then expected to make nine out of 10 monthly payments, after which their loan can be considered rehabilitated if it is sold to an eligible lender.

Creating a pathway for borrowers with defaulted loans to return to good standing provides numerous benefits for those individuals. The borrower, for example, is once again eligible for federal student aid and can take advantage of flexible student loan payment plans, such as income-based or income-contingent repayment. Even more important, the default is expunged from a borrower’s credit record, making it easier for that person to obtain other consumer loans, such as those for a house or car.

But the rehabilitation process, as currently constructed, has a couple of major flaws. First, as we previously reported, poor credit markets are making it impossible for guaranty agencies to complete the rehabilitation process by selling loans to lenders.[1]

Second, it turns out that rehabilitation does not entirely wipe a borrower’s credit history clean. As currently outlined in regulation, a guaranty agency has an obligation to remove only the record of default from a borrower’s credit history. The string of late or missed payments and period of delinquency that got a borrower into dire straits in the first place is not expunged.

Likewise, the original loan holder doesn’t have any obligation to clear the adverse history. As part of its servicing responsibilities, a lender is required to inform a consumer reporting bureau every 90 days (or quarterly) about the status of a borrower’s loan, including the amounts owed on it, and whether the loan is delinquent. But once the loan defaults, the lender hands over the title of it to the guaranty agency — meaning it no longer has responsibility to report the loan’s return to repayment status, even if it is successfully rehabilitated.

In other words, the benefits of rehabilitation are not as generous as advertised. Borrowers don’t entirely get the fresh start that has been promised.

In the legislation it recently approved, the U.S. House of Representatives took on both of these issues. The bill addresses the loan buying problem by temporarily giving guaranty agencies the authority to assign rehabilitation-ready loans to the Secretary of Education if they can’t find any lenders willing to purchase them

We were especially pleased to see that the House bill would fix the rehabilitation purchase process without providing a windfall to guaranty agencies. When we first discussed this issue, we were concerned that Congress would allow guaranty agencies to assign rehabilitation-ready loans to the Secretary of Education and still receive the fees they are legislatively promised for a loan sale (18.5 percent of the principal owed at the time of default plus another 18.5 percent charged to the borrower for collection costs). This is problematic because the non-collection cost compensation is designed as a reward for successfully locating a willing buyer, something a guaranty agency would not have to worry about if it assigns a loan to the Secretary. The bill addresses this issue by limiting guaranty agency compensation to the amount they would have received in collection costs had the loan been sold as part of a normal rehabilitation process.

The bill also prohibits consumer reporting agencies from including any adverse information on loans that are rehabilitated either through assignment or sale. Under this change, borrowers would have both their history of delinquency and default erased from their credit report, thus ensuring that rehabilitation actually provides borrowers with a clean record.

As the Senate is likely to take up the technical amendments bill soon, it is important that lawmakers preserve both of these important changes with regards to rehabilitation. If they don’t, what is supposed to be a one-time fresh start for borrowers will be little more than an empty promise.

[1] We should note that guaranty agencies had agreed to stop deducting default charges from borrowers’ state tax refunds if they have met the rehabilitation payment criterion but whose loans haven’t been sold. This process was already occurring with federal loans. This change did provide some modicum of relief, though it did not provide the other positive benefits of rehabilitation.