Navigating Student Loan Debt: Bankruptcy and Alternative Solutions

Student loan debt can be a significant burden, leaving many borrowers searching for viable solutions. While the prospect of discharging student loans through bankruptcy might seem appealing, it's crucial to understand the complexities and limitations involved. This article explores the possibility of bankrupting student loans, the "undue hardship" standard, alternative repayment options, and the impact of bankruptcy on future financial aid eligibility.

The Reality of Bankruptcy and Student Loans

The bankruptcy code has a specific section on the types of debt that don’t go away in a bankruptcy. It is difficult, but not impossible to discharge student loan debt in bankruptcy.

Bankruptcy is often considered a last resort option because of the impacts it can have on your credit and the costs and time involved in filing for bankruptcy. Heather W. a bankruptcy lawyer explains that there are very limited circumstances in which student loans can be discharged through bankruptcy.

Federal vs. Private Loans

You can discharge federal and private student loans in bankruptcy. Prior to 1976, bankruptcy law and courts considered student loans as just another type of debt that was not secured by property that could be repossessed and sold to satisfy the debt. When the number of student loans in default began to increase, Congress passed a law prohibiting elimination of federal student debt for a period of five years after origination. Consumer advocates argue that this fear of federal loss was a bit unfounded, citing a 1977 study conducted by the General Accounting Office as support. The study showed that the government was not losing a large investment due to bankruptcy filings. In 1990, lawmakers tightened restrictions even more and increased the prohibitory period from five years to seven. Then, only eight years later lawmakers amended the rule once again. It was this last amendment that eliminated any waiting period.

The Undue Hardship Standard

Your student loans will not be automatically discharged if your bankruptcy is approved. You have to take special steps in the bankruptcy case to ask the judge to discharge your student loans. This is done by filing a petition for an adversary proceeding. Though it is up to the court to decide whether you have an undue hardship, if you are trying to discharge your federal student loans, during the adversary proceeding the judge will ask the federal government ( the creditor for your federal student loans) whether or not it will agree that you have an undue hardship. The government is represented by the Department of Justice (DOJ) in the adversary proceeding. At the beginning of the proceeding, the DOJ will ask you to fill out an attestation of undue hardship.

Most court cases cite Brunner v. New York State Higher Education Services Corp. (October 14, 1987, #41, Docket 87-5013) for a definition of “undue hardship”. Brunner v. NY HESC (In re Brunner), 831 F.2d 395 (2d Cir. 1987), aff’g 46 B.R. 752 (Bankr. S.D.N.Y. 1985). That decision adopted the following three-part standard for undue hardship:

Present Ability to Pay: that the debtor cannot both repay the student loan and maintain a minimal standard of living based on current income and expenses.
Future Ability to Pay: that this situation is likely to persist for a significant portion of the repayment period of the student loans.
Good Faith Effort to Repay: that the debtor has made good faith efforts to repay the loans.

To meet the undue hardship criteria, the debtor’s financial situation must indicate a certainty of hopelessness, not merely a present inability to pay bills. Also, the circumstances must be beyond the debtor’s control.

The first element of the standard usually involves the lowest monthly payment available to the borrower, namely the monthly loan payment under Income Contingent Repayment, as opposed to standard ten-year repayment. (With the introduction of Income Based Repayment on July 1, 2009, it is expected that the courts will switch to this repayment plan as it usually yields a lower monthly payment and meshes well with the 150% of poverty line threshold for a bankruptcy fee waiver.) Note that if the borrower has multiple student loans and could afford to repay some but not all of them, the court will generally discharge only those loans that exceed the borrower’s ability to repay. It is also possible that a court will discharge part of a loan instead of the entire loan.

The poverty line is often (but not always) used as a threshold for a minimal standard of living, since it is defined as the income level at which the family has no discretion concerning how to use the income. However, the courts will generally examine all of the debtor’s expenses to ensure that they are minimal and necessary. The existence of discretionary expenses may derail an undue hardship petition, as borrowers are expected to make sacrifices to repay their debts.

The second element of the standard requires the debtor to provide evidence of additional exceptional circumstances that are strongly suggestive of a continuing insurmountable inability to repay, such as being disabled or having a disabled dependent. A serious physical or mental illness might also qualify. An inability to work in one’s chosen profession does not necessarily preclude being able to work in another field. There must be a “certainty of hopelessness”, meaning that there is no chance of any future improvement in the borrower’s financial situation.

The third element of the standard requires the borrower to have demonstrated a good faith effort to repay the loans. Filing for a bankruptcy discharge immediately after graduation is generally not considered a good faith effort to repay the loans. However, there might be extenuating circumstances, such as the debtor suffering brain damage in a car accident shortly after graduation. The court will consider the totality of the circumstances. The court will consider whether the debtor made payments on the loans when he or she had some income available and obtained a deferment or forbearance when his or her income was insufficient. The court will also consider whether the debtor took advantage of various alternatives to bankruptcy, such as the extended repayment, income-contingent repayment and income-based repayment plans, and whether the debtor tried to increase available financial resources, such as seeking a better job and reducing expenses.

With such strict criteria, not everyone will qualify for a discharge of student loan debt through bankruptcy.

The Role of the Department of Justice (DOJ)

Though it is up to the court to decide whether you have an undue hardship, if you are trying to discharge your federal student loans, during the adversary proceeding the judge will ask the federal government ( the creditor for your federal student loans) whether or not it will agree that you have an undue hardship. The government is represented by the Department of Justice (DOJ) in the adversary proceeding. At the beginning of the proceeding, the DOJ will ask you to fill out an attestation of undue hardship.

Alternative Repayment Options

However, there are other repayment options available for student loan borrowers. Bankruptcy courts will take your student loan obligations into account when reviewing your overall financial situation.

Income-Based Repayment Plans

“There’s an income-based repayment plan, and your payment can be as low as $0 if you can’t afford it. Department of Education loans,” Culp says.

Read also: Guide to UC Davis Student Housing

Deferment and Forbearance

Deferment and forbearance are also options.

Chapter 13 Bankruptcy: Reorganization and Repayment

Even though student loans are rarely eliminated in bankruptcy, there are ways to make repayment more manageable. One option is filing for Chapter 13. In this type of bankruptcy, we can help clients reorganize their debts into a structured repayment plan. Student loan payments can be included in the repayment plan, often at a reduced amount, alongside other debts. While this won’t get rid of the loans entirely, it can offer temporary relief and help avoid default or aggressive collection actions.

Co-debtor Stay in Chapter 13

“There’s a particular provision in the Chapter 13 part of the Bankruptcy Code called the co-debtor stay,” Culp says. “It prohibits the creditor from contacting co-debtors on student loan debt. The bankruptcy won’t appear in their credit history or affect their score. The creditor will get notice from the bankruptcy lawyer that the case was filed. The primary borrower can be the debtor. It could also be the cosigner if they file their own case. Chapter 13 bankruptcy, however, will stop the lawsuit against the primary borrower and the cosigner, no matter who files the case. This type of bankruptcy has a special rule protecting codebtors from collection activity.

Bankruptcy and Eligibility for Financial Aid

Will a bankruptcy affect a student’s future eligibility for student loans and other financial aid? The answer to this question is a complex one because several issues are involved. It depends on the nature of the student loan programs (federal or private) and the type of bankruptcy.

Whatever the circumstances behind the bankruptcy, the student should talk with the financial aid administrator at the school he plans to attend, and explain the situation. The financial aid administrator may be able to guide the student to certain loan programs or lenders that may fit his needs.

Federal Student Aid

Generally speaking, a bankruptcy should have no impact on eligibility for federal student aid.

A few years ago students who had their federal student loans discharged through bankruptcy were required to reaffirm the debt in order to be eligible for further federal student aid. But the Bankruptcy Reform Act of 1994 (P.L. 103-394, enacted October 22, 1994) amended the FFELP regulations dealing with loans discharged in bankruptcy. As a result of those changes, a borrower who had FFELP loans previously discharged in bankruptcy is no longer required to reaffirm those loans prior to receiving additional federal student aid.

Title IV grant or loan aid (including the Perkins loan program) may not be denied to a student who has filed bankruptcy solely on the basis of the bankruptcy determination. Financial aid administrators are precluded from citing bankruptcy as evidence of an unwillingness to repay student loans. Schools may nevertheless continue to consider the student’s post-bankruptcy credit history in determining willingness to repay the loan.

As long as there are no delinquencies or defaults on student loans currently in repayment, the student should be eligible for additional federal student loans, regardless of any past bankruptcies. However, if some of the student’s federal student loans are in default and were not included in a bankruptcy, the student will not be able to get further federal student aid until he resolves the problem. Students with loans in default should contact the lender (or servicer or current holder of the loan) to set up a satisfactory repayment plan in order to regain eligibility for federal student aid. (If the loan was discharged in bankruptcy after the borrower defaulted on the loan, it is no longer considered to be in default.)

Parents who apply for a PLUS loan (or graduate students applying for a Grad PLUS loan) may be denied a PLUS loan if they have an adverse credit history. The definition of an adverse credit history includes having had debts discharged in bankruptcy within the past five years. If this is the case, the parents may still be eligible for a PLUS loan if they secure an endorser without an adverse credit history. If the parents are turned down for a PLUS loan because of an adverse credit history, the student may be eligible for an increased unsubsidized Stafford loan.

The anti-discrimination rules appear in 11 USC 525(c):

A governmental unit that operates a student grant or loan program and a person engaged in a business that includes the making of loans guaranteed or insured under a student loan program may not deny a student grant, loan, loan guarantee, or loan insurance to a person that is or has been a debtor under this title or a bankrupt or debtor under the Bankruptcy Act, or another person with whom the debtor or bankrupt has been associated, because the debtor or bankrupt is or has been a debtor under this title or a bankrupt or debtor under the Bankruptcy Act, has been insolvent before the commencement of a case under this title or during the pendency of the case but before the debtor is granted or denied a discharge, or has not paid a debt that is dischargeable in the case under this title or that was discharged under the Bankruptcy Act.

In this section, “student loan program” means any program operated under title IV of the Higher Education Act of 1965 or a similar program operated under State or local law.

Private Loans

Private loans are an entirely different matter. Because of the many different types of bankruptcies, this is a very complex issue.

The student should contact the financial aid administrator at his school for advice on the impact of a bankruptcy on eligibility for private loans. The student should also talk to the lender and provide evidence that he is a good risk, and be prepared to explain the circumstances behind the bankruptcy. The lender may be more willing to issue a loan if the borrower offers to secure the loan. If the student is still having problems, he may want to consult the attorney who handled the bankruptcy.

Most bankruptcies will have an impact on eligibility for private loan programs, including some school loan programs. Many private loan programs have credit criteria that preclude people with a bankruptcy within the past 7 or 10 years from borrowing without a creditworthy cosigner. There are, however, exceptions if the bankruptcy was initiated for reasons beyond the borrower’s control, such as extraordinary medical costs, natural disasters, or other extenuating circumstances.

If a parent went through bankruptcy, it should have absolutely no impact on their children’s eligibility for private loans, unless the parent is required to cosign the loans.

If the bankruptcy filing included a payout plan, even if not 100%, the student will be at an advantage in applying for private loans. Bankruptcy filers with a payout plan, especially a 100% payout plan, are a better risk than most people who have gone through bankruptcy. On the other hand, if the borrower went the Chapter 7 route, he may have more difficulty in getting a private loan. Lenders tend to look less favorably on complete liquidations. Thus borrowers who filed for a Chapter 11 (or Chapter 13) and had a payout plan will be more likely to get a private loan than borrowers who filed a Chapter 7.

Lenders also look at whether the borrower is able to refile for bankruptcy. Chapter 11 filers cannot immediately refile again for bankruptcy. Although any lender should know this, they may need to be reminded. Chapter 7 files are prohibited from refiling a Chapter 7 bankruptcy for 6 years. However, Chapter 13 plans have no such restriction, so a debtor can file a Chapter 7 bankruptcy, have their debts discharged, and then file a Chapter 13 within a very short time if new debt is incurred. A debtor can file an unlimited number of Chapter 13 bankruptcies.

Qualified Education Loans and Bankruptcy Protection

Section 220 of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), P.L. 109-8, extended similar protections to “qualified education loans” starting on October 17, 2005, even when they are not funded or guaranteed by a nonprofit organization. Qualified education loans is defined to include any debt incurred by the taxpayer solely for the purpose of paying for qualified higher education expenses of the taxpayer, the taxpayer’s spouse, or any dependent of the taxpayer. (Dependency is determined as of the time the taxpayer took out the loan.) Interestingly enough, most private student loan programs seem to have some sort of nonprofit involvement.

BAPCPA also made it more difficult to file under Chapter 7. If the borrower’s income is above the median income in his/her state or is sufficient to repay 25% or more of his/her debt, the borrower will be forced to file under Chapter 13, which requires repayment over three to five years. BAPCPA also mandates credit counseling before a borrower can file for bankruptcy.

Limitations on Exception to Discharge of Private Student Loans

In addition, the loans must be for study at a school that is eligible to participate in Title IV programs and where the student is enrolled at least half time. Loans that don’t meet this definition, such as credit card debt, are still dischargeable even if they were used to pay for higher education expenses.

Thus FFELP and FDSLP loans, and education loans funded or guaranteed by private nonprofit organizations, are automatically nondischargeable in a bankruptcy proceeding. The only cases in which they can be discharged through bankruptcy are: if the borrower files an undue hardship petition and then it is up to the judge to decide whether the loan can actually be discharged. (The Higher Education Amendments of 1998 repealed the provision that allowed for the discharge of education loans that had been in repayment for 7 years. This affects all bankruptcy proceedings initiated after October 7, 1998, regardless of whether they involve loans incurred before that date.)

It is worth noting that the extension of the bankruptcy exception to qualified education loans in 11 USC 523(a)(8)(B) cross-references IRC section 221(d)(1) for the definition of a qualified education loan. This section of the Internal Revenue Code requires the loan to be used “solely to pay qualified higher education expenses”. 1087ll, as in effect on the day before the date of the enactment of this Act) at an eligible educational institution, reduced by the sum of -the amount excluded from gross income under section 127, 135, 529, or 530 by reason of such expenses, andthe amount of any scholarship, allowance, or payment described in section 25A (g)(2).

So to qualify for this exception, the private student loan must be capped at the cost of attendance minus student aid, such as scholarships, and expenses paid for using amounts from employer tuition assistance, 529 college savings plans and prepaid tuition plans, US savings bonds and Coverdell education savings accounts. If a borrower were able to show that the loan exceeded the limits set by IRC section 221(d)(2), they might be able to argue that the loan was ineligible for bankruptcy protection and so should be subject to discharge. See IRS Tax Topic 456 and IRS Publication 970 for further IRS guidance on what types of expenses qualify, such as the requirement that the expenses must have been “paid or incurred within a reasonable time before or after you took out the loan” (per IRC section 221(d)(1)(B)). IRS Publication 970 provides a safe harbor of 90 days before and after the academic period to which the expenses relate. Consolidation loans and other loans used to refinance a qualified education loan also qualify, provided that there was no cash out from the refinance (or that the cash out was used solely for qualified higher education expenses). Eligible student is defined by IRC section 25A(3) as a student enrolled at least half time in a degree or certificate program at a Title IV institution (per Section 484(a)(1) of the Higher Education Act of 1965). More details and other limitations on the exception to discharge can be found in Limitations on Exception to Discharge of Private Student Loans.

Seeking Professional Guidance

If you have questions about student loans and debt relief, contact an experienced bankruptcy lawyer for guidance and support.

The Cost of Bankruptcy

The cost of getting help with bankruptcy will vary depending on the type of bankruptcy you’re seeking and the complexity of your case. Most bankruptcy lawyers will do a Chapter 7 bankruptcy for a flat fee. Many struggling borrowers often wonder if the cost is worth it.

“Whether it’s a $1,000 attorney fee, a $5,000 attorney fee, a $20,000 attorney fee, it’s my job to help you find the best way out of a bad situation,” Culp says. “And if you wind up finding that your best way out is paying a $3,500 attorney fee to discharge $150,000 worth of credit card debt and medical debt, that’s a good day, all day, every day.

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