Catch on student loans: If co-signer dies, pay up

Most borrowers who get privately issued student loans need a co-signer, and could face lender demands for full repayment if the co-signer dies or files for bankruptcy, a new federal report says Tuesday.

Automatic defaults occur even when the private loans, often co-signed by parents or other relatives, are being repaid on time — and they can trigger a negative credit report, according to the Consumer Financial Protection Bureau report.

Borrowers also told the bureau's student loan ombudsman office they face bureaucratic hurdles when they try to get co-signers released from the loans, the report said.

The CFPB said it did not have data on the frequency of automatic defaults, which are legal. But the issue has arisen repeatedly in borrower complaints, said ombudsman Rohit Chopra.

"Where we worry is that because we continue to see it over time, and we're seeing it with more companies, this is something that can be really troublesome, to put it lightly, for a borrower," said Chopra. "Especially one who's just dealing with the loss of a parent."

"We want to make sure that lenders are really looking at this policy" before the issue becomes a bigger issue, added Chopra. He said the CFPB would welcome information from all industry participants.

U.S. student loan debt reached nearly $1.2 trillion last year, the CFPB said. Most of that debt involves federal loans, which usually don't require co-signers.

However, U.S. consumers owe roughly $150 billion in private student loan debt, the CFPB and Department of Education said in a 2012 report to the Senate banking committee. And 90% of private student loans issued in 2011 had co-signers, up from 67% in 2008, that report said.

Automatic default provisions are in the written terms of many private student loans. But borrowers may not realize it before getting formal notices from a lender or loan servicer or calls from debt collectors. They could face a credit downgrade in as little as 30 days because some loan terms authorize default declarations "upon death or filing of bankruptcy" by a co-signer, said Chopra.

Borrowers who try to get co-signers released from loans discover that required forms are often not available on websites or in electronic form, the CFPB reported. Many lenders conduct credit checks before releasing a co-signer, but they don't always disclose the minimum qualification standards, the report said.

Additionally, the loans may have been sold by the lender and packaged in a pool of securitized debt. That could make it harder for borrowers to win approval to release co-signers from the loans.

The CFPB report said lenders who pursue automatic defaults could also face problems, including lower interest income, reduced recovery of principal, poor customer experience and negative reputation risk.

"While these acceleration options may have a legitimate business purpose, it seems that private student lenders and servicers may not always be acting in their own self-interest by accelerating balances and placing loans in default," said the CFPB report.