A top official at the Consumer Financial Protection Bureau on Tuesday said student loan companies are at risk of breaking the law if they place people in default when the co-signer of their loan dies or declares bankruptcy, signaling that the bureau may start legal action.
These “auto defaults” leave borrowers with no choice but to repay the full balance or ruin their credit, making it difficult to purchase a home or car. The practice occurs in the private student loan market, where banks and other financial firms provide education financing with loan contracts that give them the right to trigger a default, even if the loan is being paid on time. Despite asking lenders to strip the clause from their contracts, bureau officials say many have not and are skirting the law by unfairly invoking the clause.
Speaking at a Consumer Bankers Association conference Tuesday, CFPB student loan ombudsman Seth Frotman told attendees that examiners identified ambiguous clauses that failed to spell out the terms, which could be considered an unfair and deceptive practice in violation of the law. In some cases, he said, consumers only discovered the fate of their loans when loan servicers, the middlemen who collect and apply debt payments, refused to accept any money or they were contacted by a debt collector.
A part of the problem is that private student loans are sold and bundled in with other loans, so while one lender may may not engage in auto defaults there is no guarantee that the next owner will do the same. What’s more, 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.
“Simply extending promises to the public that auto-default provisions will not be exercised is hollow and incomplete because future loan holders may decide to enforce these clauses,” Frotman said. “If the status quo persists, I am afraid we will continue to hear from borrowers who are subjected to this practice, and we will be having this same conversation for years to come—a situation I believe none of us want.”
When parents or grandparents shoulder the legal responsibility of a loan, students can get lower interest rates because the co-signers are obligated to repay the debt if the borrower does not.
Lenders readily require a co-signer to make the debt more attractive for packaging the loans into securities sold to investors. They 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 have borrowers jump through additional hoops to get such a release, according the CFPB. They ask for proof of graduation, transcripts, employment or salary, and even conduct credit checks.
The bureau first brought attention to auto defaults two years ago after receiving complaints from consumers whose loans were placed in default because of the death or bankruptcy of a co-signer. At the time, the bureau asked lenders to give borrowers the chance to find another co-signer and issued a set of sample letters that consumers could use to request that lenders release a co-signer from the contract.
In response to Frotman’s remarks, Richard Hunt, president and CEO of the Consumer Bankers Association, said, “It is not the practice of our member banks to accelerate loans in the event the co-borrower dies or goes through bankruptcy. In fact, many of our members have been actively working to remove clauses that would permit such practices from their new contracts.”
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