Student loan borrowers have mixed incentives around whether and when to exit default. Staying in default for many years can result in wage garnishment and tax refund offsets, leading to further financial strain. But our new analysis suggests exiting default, attempting to repay, but then defaulting again, may harm their credit more than if they had stayed in default.

Expanding eligibility for loan rehabilitation and reevaluating how default affects credit among defaulted borrowers could incentivize exiting default and protect defaulted borrowers from the worst credit outcomes.

Defaulted borrowers’ options

If a defaulted borrower doesn’t repay their loan in full, their options for exiting default are loan rehabilitation or consolidation.

Loan rehabilitation requires nine voluntary payments and erases the default from a borrower’s credit record once the loan is back in good standing—but it can only be used once. Consolidation involves taking out a new loan to repay the defaulted debt, but it doesn’t remove the default from the borrower’s credit history. After exiting default through rehabilitation or consolidation, borrowers can default again on their student loan if they’re unable to keep up with payments.

Over a quarter of borrowers will face one of these options. We recently found 27 percent of borrowers who held student debt at some point between 2010 and 2019 defaulted at least once during that period. Two-thirds of those who defaulted experienced one long-term default (at least three years) and another 11 percent had multiple defaults.

The contradictory incentives of defaulting

Leading up to a default, a borrower’s credit score typically drops by 50 to 90 points. If they stay in default for several years, the missed payments that led up to the default may be weighted less in their credit score calculation as more time passes, allowing them to build their credit back up.

However, borrowers who stay in default for many years may also be subject to collections processes like wage garnishments and tax refund offsets and could ultimately see longer repayment timelines. These processes take time to initiate, often don’t begin until years after a borrower first defaults, and may economically strain borrowers. The risk of these involuntary collections and their associated fees may incentivize borrowers to put their loans back in good standing and attempt to voluntarily repay the debt before collections begin.

Because wage garnishment and tax refund offsets take time to begin, a borrower who exits default relatively quickly is at low risk of experiencing these collections. However, if after exiting default the borrower tries to repay the loan but cannot keep up with payments, they have more recent delinquencies reported that affect their credit.

And because borrowers can only rehabilitate a loan once, they cannot erase a second default from their credit record. So, a borrower who attempts to repay, if ultimately unable to do so, sees their credit score suffer. This may discourage the borrower from putting loans back in good standing and attempting to repay the debt.

The implications of multiple defaults versus long-term default for credit scores

To examine the potential credit effects of these contradictory incentives, we compare credit score trajectories after the initial default for long-term defaulters and for those who default multiple times. We analyze 2010–19 credit bureau data and find the change in credit scores relative to the time of initial default two, four, and six years later.

Over time, an increasing percentage of those with a long-term default saw a large increase in their credit score. Six years after default, 43 percent of long-term defaulters had improved their credit score by more than 90 points, compared with only 27 percent of multiple defaulters. This gap between those with one long-term default and those with multiple defaults grows each successive year after default.

The percentage of long-term defaulters whose credit scores decreased or stayed the same after default is consistently much smaller than the share of multiple defaulters. After six years, just 15 percent of long-term defaulters had the same or lower credit scores than in their first year of default, compared with 31 percent of multiple defaulters.

The difference in default pattern likely plays a major role in these credit score trajectory differences, because those with one long-term default see similar trends in the rate of holding utility and medical collections debt during the years after an initial default as those with multiple defaults. This suggests their overall financial health outside of their student debt may be similar.

These results demonstrate the risk that comes with exiting default and then being unable to keep up with payments. Eighty-five percent of long-term defaulters saw their credit scores increase six years after their first default, with 43 percent of long-term defaulters raising their credit scores by more than 90 points.

For multiple defaulters, redefaulting after attempting to repay may have hurt their ability to improve their credit scores. Only 69 percent of multiple defaulters raised their credit scores six years after their first default, with most of those increases being small or moderate.

How to incentivize exiting default while reducing credit risk

Borrowers in default may be hesitant to exit because of how redefaulting would negatively affect their credit, compared with staying in default. But staying in default could lead to wage garnishment, tax refund offsets, and further economic insecurity. There are two ways federal policymakers and credit bureaus could address this.

1. Allow for loan rehabilitation more than once. This would help borrowers who default multiple times to exit default and build up their credit more quickly. And because federal loans are now overwhelmingly held by the government, with only a small share of privately held federal loans, the rehabilitation process is logistically simpler than it used to be for most loans.
2. Reevaluate how missed payments after default affect credit scores. If borrowers who redefault aren’t more of a credit risk than those who stay in default, as some evidence suggests, then the way credit scores are currently treated may not accurately represent their ability to pay. Reevaluating how credit scores are calculated for these borrowers and whether they accurately represent credit risk could better align incentives for exiting default.