Q: I am at month 11 of a student loan rehabilitation program for a defaulted loan of about $80,000. I have made 10 on time monthly payments of $550. My parents will help me offer a lump sum payment to settle this debt. I am looking at offering $30,000 to $40,000. The collection agency wants $50,000. What should I know to negotiate a fair sum?

A: Frankly, I wasn’t aware that student loan companies or loan servicers were willing at all to negotiate lump sum settlements for student loan debts.

Frankly, why do they have to, considering the power they wield over debtors? They can report your delinquency to the credit bureaus, they can garnish your wages, they can take tax refund checks, and student loans have no statute of limitations, meaning that creditors can chase you down for this debt until you retire.

And even then, they can snatch any pension or social security check you might get. On top of all this, you can’t even wipe out student loans in bankruptcy court. With all this leverage, I’m shocked that some company has entertained the idea of a lump sum settlement.

To be honest, I don’t think you should do a “settlement” because of the many drawbacks to settling a debt. In a nutshell, when you settle a debt, your credit takes a hit, because the obligation gets reported as a settlement or partial payment.

Any reporting to the credit bureau that shows you didn’t pay as agreed will lower your credit score. And isn’t that one of the benefits you’re getting from going through loan rehabilitation? Rehabbing a student loan wipes your negative credit history out in terms of past due student loans that were reported to the credit bureaus. Settlements will put some black marks back on your credit records.

Additionally, when you negotiate a settlement with any financial company or government agency, they send you a 1099-C. This reports the amount of debt canceled or forgiven. That “forgiven” amount is considered gross income and is taxable by the government.

So if you do get a settlement for, say, $40,000 on that $80,000 in student loan debt, the other $40,000 that is purportedly wiped out in the settlement agreement is taxable at your ordinary income tax rate.  If you’re in the 25% rate, that means you’ll be stuck with a $10,000 tax bill.

Finally, I’m just suspect about this whole deal. What recourse would you have if you fork over tens of thousands of dollars to a company and then they say “Sorry, but we never had a deal.” You can reduce this risk, of course, by getting an agreement in writing upfront.

But my point is that the student loan company, or collection agency, could probably rightfully show a judge (if it got that far) that you did, in fact, owe $80,000. There’s certainly no law that
requires them to reduce or settle your debt.  Then you’d be on the hook for the remaining balance — even after thinking you had a properly agreed-upon “settlement” deal.

I think a better strategy, especially since you have supportive parents, is to let your parents help you make a hefty lump sum payment, but to bite the bullet and pay the $80,000 that you owe. Let’s say you pay $40,000 in a lump sum. All of that money should go toward your principal balance. That will knock out a huge amount of interest charges – more than $15,000 in interest, according to the financial calculator at www.FinAid.org.

Visit that site and play around a bit with various loan repayment options. At first glance, it may sound foolish to pay $80,000 when you think you can possibly pay $40,000. But look at it this way: that $40,000 lump sum settlement will really be $55,000, when you factor in taxes. Now take a look at the hit to your credit for the next seven years.

In my opinion it’s worth it to pay the other $25,000 to preserve your credit. If you can keep a good credit rating, you’ll probably save way more than that “extra” $25,000 if you have to get other loans, like a mortgage, credit cards, auto loan or other student loans.