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Personal finance

Cosigners’ deaths put student loans in default

Borrowers who pay off private student loans on time can be deemed in default if a cosigner dies or goes bankrupt.

David L Ryan/Globe Staff/File 2010

Borrowers who pay off private student loans on time can be deemed in default if a cosigner dies or goes bankrupt.

Some people who pay private student loans on time are being placed in default when the cosigners of their loans die or declare bankruptcy, the Consumer Financial Protection Bureau said 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.

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The practice occurs in the private student loan market in which banks and other financial companies 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 cosign 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 cosigned. 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 cosigner — even if the loan was being paid on time.

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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 cosigner.

The bureau issued sample letters that consumers could use to petition lenders to release a cosigner from the contract.

Having parents or grandparents shoulder the legal responsibility of a loan can result in a lower interest rate because the cosigners are obligated to repay the loan if the borrower does not.

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‘‘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 Monday.

Lenders will typically release a cosigner 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 requirements for these releases. One borrower said the lender promised to release his cosigner after he made 28 on-time payments, but upped the number to 36 once the borrower reached the original goal.

Without the cosigner release, borrowers can face an automatic default when their cosigners die or file for bankruptcy protection. 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. Following the financial crisis, lenders readily required a cosigner to make the debt more attractive for packaging the loans into securities that were 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. Yet the majority of the complaints the consumer bureau received were about the companies, including Sallie Mae and American Education Services, that service the loans.

Requests for comment on the report from Sallie Mae and AES were not immediately responded to.

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