Some people who pay private student loans on time are being placed in default when the co-signer of their loans dies or declares bankruptcy, the Consumer Financial Protection Bureau said in a report due out Tuesday.
These “auto defaults” force borrowers to either immediately repay the full loan balance or ruin their credit, hurting their chances of getting a job, renting an apartment or buying a car.
The practice occurs in the private student loan market in which banks and other financial firms provide education financing. Private loans generally carry higher interest rates and fewer protections than federal loans, and borrowers are often required to have someone else co-sign the agreement to ensure repayment.
In its mid-year report on student loan complaints, the consumer bureau highlighted grievances that have emerged with more than 90 percent of private loans now being co-signed. Chief among the 2,300 complaints about private student loans submitted to the bureau in the past five months was the triggering of a default by the death or bankruptcy of a co-signer, even if the loan was being paid on time.
To ease the burden on borrowers, the CFPB recommends that lenders consider alternatives to these defaults, such as giving the borrower the chance to find another co-signer. The bureau issued a set of sample letters that consumers could use to petition lenders to release a co-signer from the contract.
Having parents or grandparents shoulder the legal responsibility of a loan can result in a lower interest rate because the co-signers are obligated to repay the loan if the borrower does not.
“Private student loans can sometimes take many years to pay off, and parents or grandparents may be unaware that their own financial distress or death can lead to a sudden default and demand for payment in full,” Rohit Chopra, student loan ombudsman for the CFPB, said during a call with reporters Monday.
Lenders will typically release a co-signer from the loan agreement if the borrower has made consistent on-time payments. Yet some lenders and loan servicers — the middlemen who accept and apply payments to the debt — have borrowers jump through additional hoops to get such a release, according the report. They ask for proof of graduation, transcripts, employment or salary, and even conduct credit checks.
Consumers have complained to the bureau that lenders have inexplicably changed the requirement for these releases. One borrower said the lender promised to release his co-signer after he made 28 on-time payments, but upped the number to 36 once the borrower reached the original goal.
Without the co-signer release, borrowers can face an auto-default when their co-signer dies or files for bankruptcy. Many private student loan contracts contain clauses that allow a private student lender to demand the entire balance immediately and place the loan in default if the balance isn’t paid.
Chopra said such stringent terms may be the result of financial market practices regarding private student loans. In the wake of the financial crisis, lenders readily required a co-signer to make the debt more attractive for packaging the loans into securities sold to investors.
The contracts on those securities often come with restrictions that could make it difficult for the company servicing the loan to make adjustments for individual borrowers, Chopra said.
“This is something investors should be aware of; they should know that they may not be maximizing value from those customers,” Chopra said. “It doesn’t seem that there is a real thoughtful business decision going along” in these auto defaults.
Private student loans account for $150 billion of the $1.2 trillion in outstanding student loan debt but represent a disproportionate amount of the complaints received by government agencies. The market is dominated by such financial giants as Citigroup, JPMorgan Chase, Wells Fargo and Discover Financial Services.
John Rasmussen, head of education financial services at Wells Fargo, said only 2 percent of its student loan customers experience an “unforeseen circumstance” that affects their ability to repay.
“When this happens, we will exhaust all available options to help the customer through their hardship,” he said. “Wells Fargo does not accelerate debt repayment on the student customer when the co-signer passes away or files bankruptcy.”
The lion’s share of student loan complaints that the CFPB received were about the companies that service the loans, including Sallie Mae and American Education Services (AES). Requests for comment on the report from Sallie Mae and AES were not immediately returned.