Student Loans & Bankruptcy: Dischargeable Debts & More
It’s no secret that student loan debt is a sleeping giant that seems to be stirring from its slumber. And while you might assume that you won’t have the healing powers of a bankruptcy discharge in your arsenal when facing this monster. You see, general wisdom holds that student loans cannot be discharged in either Chapter 7 or Chapter 13 bankruptcy. That’s both right and wrong.
One exception to this rule – the so-called Undue Hardship Rule – states that:
If you can prove to the bankruptcy court that repaying your student loans would impose an undue hardship on you and your dependents, the court may discharge a portion or all of your student loans.
Conventional wisdom would also have you believe that getting your loans discharged through the undue hardship exception is extremely rare and painstakingly difficult to qualify for. But the only reason it’s considered rare is only 0.1% of bankruptcy debtors attempt to discharge their debt.
Nearly 40% of debtors who petition for discharge on the basis of undue hardship are actually granted it, according to the American Bankruptcy Law Journal.
So keep reading to learn more about how student loans are handled in bankruptcy, how the undue hardship process works and the best practices recommended by student debt experts.
While the majority of student borrowers get their loans through federal programs and therefore benefit from various repayment options in the event they encounter income issues, those who currently owe more than $150 billion to private lenders aren’t so lucky.
Private borrowers are in an even worse situation. Private lenders are often unable to offer repayment flexibility due to a couple of major legal handcuffs, including the fact that most of their loans are bundled and rolled intro trusts. That’s something we heard over and over again while talking to student loan experts about the growing debt problem and the Consumer Financial Protection Bureau’s call for ideas on how to solve it.
With that being said, certain types of student loans – both government-sponsored and private – can be discharged through bankruptcy without even meeting undue hardship standards.
The following types of student loans can be discharged with the undue hardship exception:
- Private Student Loans
- Federal Direct Loans
- Federal Family Education Loan (FFEL)
- Federal Perkins Loans
- Health Education Assistance Loans (uses a different test that requires due date of at least 7 years and proving that repayment would cause an “unconscionable burden”)
To discharge Parent PLUS Loans, the parent – not the child – must file for bankruptcy.
The issue of how to handle student loans in bankruptcy is actually a pressing one, according to the experts we consulted. Almost to a man, they said that while bankruptcy laws aren’t likely to change anytime soon given the current political landscape, allowing the discharge of student loans would effectively force lenders to work with borrowers in order to get at least a partial payment.
Until then, student borrowers can and should consider the discharge benefits of bankruptcy if they encounter serious payment difficulties.
The bankruptcy court will not proactively determine whether repayment of your loans would cause you and your dependents undue financial hardship. You must jumpstart the process. You can do so after filing for Chapter 7 or 13 by submitting a complaint known as an “adversary proceeding.” A knowledgeable bankruptcy attorney can help you prepare and file this document.
Once the court receives your complaint, it will conduct an adversary proceeding, which your lenders will be permitted to attend in order to challenge your complaint.
Determining Undue Hardship:
The court will apply a certain test to your finances in order to detect the likelihood of undue hardship. The most common one is called the Brunner Test. However, some courts use the Totality of the Circumstances Test or others less common.
The Brunner Test considers three factors, all of which must be present in your case:
Poverty: Based on your current income level and expenses, you and your dependents would not be able to maintain a “minimal” standard of living if you’re forced to repay your student loans. Currently, no general guideline exists regarding what constitutes a “minimal” standard of living.
Each bankruptcy judge determines this at his or her discretion. Often, however, “minimal” describes the ability to live only at the poverty level for a foreseeable future.
- Persistence: There is circumstantial evidence that the undue hardship is likely to continue for a significant portion of the student loan repayment period.
- Good Faith: You made a “good faith” (your best) effort to repay your student loans — some courts may require a minimum of 5 years — before filing for bankruptcy.
Pending the court’s decision, you do not need to continue paying your student loans. When you file for bankruptcy, a federal injunction called the automatic stay immediately suspends most collection efforts — including attempts from your loan servicer — while your case is open or until the court permits your creditors to pursue action.
If Your Discharge Is Approved:
If you pass the Brunner Test, the court will completely or only partially cancel your student loans. You will be obligated to repay only the portion that is not discharged, and collection efforts will resume when your bankruptcy case concludes.
If all of your student loans are canceled, you will no longer be liable for the debt and all collection efforts will cease permanently. At this point, if you were previously ineligible for federal student aid, you will regain your eligibility status and may reapply then.
If Your Discharge Is Denied:
If you fail the Brunner Test, you will need to continue repaying the balance on your student loans upon discharge or when the court allows your creditors to resume collection.
However, Chapter 13 can still provide relief. In a Chapter 13 repayment plan, your income relative to your expenses determines the amount you must pay on your student loans over three to five years. If your disposable income is too low, you may only need to pay your loans after at the end of your case, but the loans will continue to accrue interest. With sufficient disposable income, you’ll pay back only what you can afford (usually lower than your regular monthly payment) during your plan period.
With all of the outlets purporting the idea, one must wonder where the notion that student loans can’t be discharged in bankruptcy originates from. The most likely answer is that this mystery developed almost like a game of telephone from the perception that it’s “nearly impossible” to do so, which itself stems from a pair of key pieces of legislation.
In 1978, Congress passed the Bankruptcy Reform Act, which contained a provision limiting the discharge of student loans obtained through federally-backed programs or through non-profit institutions unless the borrower showed undue hardship or the loan came due at least seven years prior to filing (this seven-year rule was later eliminated for cases brought after October 1, 1988). Disallowing federal loan discharges made sense not only because it protected taxpayers, who ultimately foot the bill for federal loans, but also given that federal loans aren’t credit underwritten. In other words, proving your responsibility as a consumer isn’t a prerequisite for getting a federal student loan, and with an easy path to non-payment defaults would come in droves.
There are few, if any, reasonable rationales for the 2005 expansion of the law to include private student loans. There aren’t any taxpayer interests to consider when it comes to private loans, and since they require a credit check, it would seem that the risk of borrower bankruptcy would be burden of lenders alone. Some have argued that restricting the ability of borrowers to discharge private student loans in bankruptcy offers interest rate benefits, but that claim doesn’t seem to hold much water either.
Sure, people have claimed in the past that limiting the ability of borrowers to discharge private student loans in bankruptcy
It’s with that background and the context of the current indebted landscape in mind that Sens. Dick Durbin (D-Ill.), Jack Reed (D-Ill.) and Sheldon Whitehouse (D-R.I.) recently introduced the Fairness for Struggling Students Act of 2013. This proposed legislation promised to essentially nullify the aforementioned 2005 policy shift and roll bankruptcy laws back into the late-’70s. Despite fairly significant support from industry insiders, activists and the general public alike, this would-be law died the same committee death that so many other bills have endured in recent years.
Student debt can be overwhelming. But you need to weigh each of your options before attempting to discharge your loans through bankruptcy. Follow the advice below to avoid regrets.
Understand the Consequences: Before you resort to bankruptcy because of overwhelming student loan debt, you should first familiarize yourself with the ramifications of filing. Aside from filing costs, legal fees and a stack of time-sensitive paperwork, you could also lose property and tarnish your credit history. Bankruptcy can stay on your credit report for up to ten years, depending on whether you file for Chapter 7 or Chapter 13
There are also limits on how often you can file, so if you’re not successful this time around, you may be left with the same debt and less money.
- Look into Non-Bankruptcy Options: There is a variety of strategies you can employ to deal with overburdensome student loans. For starters, federal student loans offer a number of income-based repayment programs. You could also get the remainder of your balance forgiven if you work in a qualifying public service job for the federal government and make 10 years of student loan payments. Another option is to transfer part of your student loan balance to a 0% credit card, but you need good credit to make that worthwhile. You could also take out a personal loan to pay off your student loan, but you will need to get better terms than your student loan offers.
- Talk to a Credit Counselor: Often, debtors are quick to decide on bankruptcy without knowing the full scope of their problem. And often their financial problems can be fixed with the help of a credit counselor. Before you ruin your credit history by filing for bankruptcy, visit with a professional credit counselor who will examine your finances and suggest a game plan for tackling the problem based on your goals — often for free.
Hire a Bankruptcy Attorney: Bankruptcy court rules are strict, and even the tiniest missteps can result in dismissal of your case, which not only leaves you mired in debt but also with a blemished credit record. An experienced bankruptcy attorney can guide you through the entire bankruptcy process, including the possibility of discharging student loan debt.
Start by comparing bankruptcy attorneys in your area through WalletHub’s database. As you speak with each one, ask many questions about his or her experience handling student loans in bankruptcy. You want to make sure your lawyer understands the process before going in.
Learn the Rules of Your Court: Although the bankruptcy automatic stay means you don’t have to keep making payments on your student loans during the life of your case, you may be wondering whether you can halt the accrual of interest. You want to stop incurring interest as soon as possible, after all, in case your debt – or a portion of it – does not get discharged, in which case you would have to pay interest for the time the automatic stay was in effect. The answer ultimately depends on where you live and which bankruptcy chapter you file.
In Chapter 7, student loans are among the debts that can be discharged completely, assuming you can prove undue hardship. Chapter 13 debts, however, are repaid based on priority, which means some courts won’t allow you to continue student loan payments – at least right away. This is designed to prevent unfair discrimination against other unsecured debts, and your case could be dismissed if you keep paying.
Some jurisdictions, however, will allow you to keep making payments and even prioritize your student loan debt over others. Ask your attorney about the rules in your area before making payments in an active case.
Given the complexity of managing student loans in bankruptcy proceedings, we turned to a panel of leading experts for insights that can save borrowers lots of time, money and hassle. You can check out both our experts and their responses below.
- If a debtor cannot discharge his or her student loan debt through bankruptcy, what are other effective ways to reduce or eliminate that debt?
- What types of public policy changes can Americans expect in the future with regard to student loan debt?
If a debtor is struggling with the burden of loan repayment, I would recommend looking into the Pay as You Earn (PAYE) loan repayment plan. Under PAYE, a debtor will either pay 10% of his/her discretionary income or what he/she would have paid under the Standard Repayment Plan. After 20 years of on-time payments, the remaining balance on the loan is forgiven. The amount forgiven is considered taxable income.
Under PAYE, if a debtor is unemployed, the income-adjusted payment amount is $0. Making a $0 payment counts as an on-time payment, so the debtor can begin whittling away at those 20 years of payments at no cost. A debtor should never have to put his/her loans in deferment because with PAYE a debtor should always be able to make an on-time payment, regardless of his or her income. A debtor will typically pay more for his/her loans over time under PAYE than the Standard Repayment Plan, so PAYE is by no means the right plan for everyone.
I would also recommend looking into the Public Service Loan Forgiveness Program (PSLF). If the debtor is working full-time for a government agency or non-profit (501c3), he/she is eligible for PSLF. Under PSLF, once the debtor has made 120 on-time, monthly payments, the remaining balance on his/her loan will be forgiven. A debtor should use PAYE to maximize the amount forgiven under PSLF. Loans forgiven under PSLF are not considered taxable income.
Student loan debt can be discharged in bankruptcy ONLY if the student can prove that repayment would cause “undue hardship” and this standard is very difficult to meet. Therefore, students must find ways to ensure repayment of their student loans to prevent default.
One place to investigate are Public Service Loan Forgiveness Programs, such as AmeriCorps or Peace Corps, where full-time employment can reduce student debt. Certain college majors may have loan forgiveness built into the occupation, such as doctors or veterinarians, through federal or state incentive programs if the student agrees to work in high-need areas for a certain period of time. However, loan amount totals that are forgiven may be included in the student’s income and subject to taxes.
There is always the “old fashioned way” of cutting non-essential expenses, such as dining out or entertainment, and putting the money saved toward student debt. Even small amounts paid over time will add up and reduce debt at a faster rate.
Students can try to find more affordable college options, such as starting off in a community college, before committing to large amounts of student debt. When it comes to student loans, it is much easier to “play offense rather than defense.” Not taking loans out in the first place is probably the best option of all. Smart students will pick colleges based on their affordability more than the name.
Students must realize that taking on student loan debt is serious business. Students don’t seem to grasp the concept of debt while they are in college. It’s not until their loan repayment kicks in when students start to realize that having a large amount of debt feels like “an elephant sitting on your chest.” By then, it’s too late and repayment is the only option. Don’t wait until after graduation to fully understand student debt. Students should make sure that repayment will be a viable option before taking out student loans.
- For those currently in college, it is important to join a financial institution whose products are designed with students in mind. At CFE Federal Credit Union, we offer free student checking accounts for students at the University of Central Florida. Our student checking accounts allow UCF students to develop lifelong financial management skills without the stress of monthly service fees.
- Your credit is your reputation as a borrower. One way that CFE Federal Credit Union encourages students to build credit is through a secured credit card. Secured credit cards help borrowers establish positive payment habits that are reported to the credit bureaus.
- The best way to prepare for the future is to contribute to your savings account regularly. Remember to pay yourself first by saving a portion of every paycheck for emergencies. Establishing that emergency savings will help borrowers meet their obligations further down the road.
- One effective way to reduce or eliminate student debt is to pay more than the minimum payment if you are comfortable meeting your other obligations.
- Borrowers can save the most money on interest by paying off the debt with the highest interest rate.
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