Ask The Experts: Bankruptcy Laws & Student Loans
It’s no secret that student loan debt is a sleeping giant that seems to be stirring from its slumber. Those who’ve pursued higher education and the lifestyle that ostensibly comes with it collectively owe more than $1 trillion to lenders.
While the majority of borrowers got 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 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.
Another purported impediment is the widely-reported “fact” that student loans can’t be discharged in bankruptcy. 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. 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. Something is better than nothing, after all.
Naturally, that got us curious and we sought out a few leading bankruptcy experts for answers. Interestingly, they told us that not only can student loans be discharged in bankruptcy, but the idea that they can’t be is also somewhat of a self-fulfilling prophecy.
So, let’s set the record straight with a few facts about the actual dynamics in play when it comes to student loans and bankruptcy:
- Student loans can be discharged, though it’s harder to do so than with other types of debt.
- In order to discharge a student loan, you must meet a three-part “undue burden” test, known as the Brunner Test.
- If forced to pay off student loans, the debtor will be unable to maintain a minimal standard of living for him or herself as well as any dependents, based on current income and expenses.
- The debtor’s financial situation is unlikely to change during the majority of his or her repayment period.
- The debtor has made good-faith efforts to repay amounts owed.
- Roughly 40% of distressed borrowers who attempt to discharge student loan debt are successful, according to a widely-quoted Harvard Law study.
- The vast majority of struggling borrowers never even try to discharge their student loan debt due to the prevailing notion that it’s not allowed.
You therefore have to wonder where the idea that student loans can’t be discharged came from. The most likely answer to this mystery is that it 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 would essentially nullify the aforementioned 2005 policy shift and roll bankruptcy laws back into the late-’70s. It’s also likely to garner a great deal of support industry insiders, activists, and the general public alike.
While we’ll have to wait and see what the future holds for this would-be law, it’s clear that if things keep going the way they are now it will be hard for politicians to vote “No.”
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Many, many student loan debtors don’t seek to have their student loans discharged and, of course, that makes the statistics much worse because if you don’t even seek to have your student loan discharged, they’re not going to be discharged. The debtors don’t think they’re dischargeable. The lawyers who represent the debtors either don’t think they’re dischargeable or don’t want to incur the time and cost of filing an adversary proceeding to obtain discharge of a student loan because most of them are working on a flat fee basis for kind of a standard Chapter 7. If they file an adversary, then that costs extra and their clients don’t necessarily have the money to pay them.