For a long time now, student loans have been pretty much prohibited from being discharged through bankruptcy. That could change by the looks of this proposal. The S.2598 – FRESH START Through Bankruptcy Act has been recently referred to committee.
Why is it so hard, if not impossible, for people to get rid of student loans through bankruptcy now?
Due to a 1976 law, student loans are not allowed to be treated like other forms of debt (ie: credit cards or car loans). This comes from a federal commission on bankruptcy laws that heard testimony claiming the discharge of student loans could damage federal student loan programs. Congress was concerned that students could borrow thousands from the federal government, then graduate, then file bankruptcy, and never repay their student loan debt.
So as an extension of the Higher Education Act of 1965, Congress passed the 1976 law, which made borrowers wait five years after the first student loan payment was due before they could have the loan discharged through bankruptcy. Congress created an exception that allowed for discharge within that five-year period if the loan caused “undue hardship.” Then Congress extended the five-year bankruptcy ban to seven years in 1990. Then in 1998, Congress extended it to the borrower’s lifetime! Currently the “undue hardship” exemption, which is a much higher threshold than many other forms of debt, is the only way to have student loans discharged in bankruptcy. This higher threshold includes both federal student loans and, since 2005, most forms of private student loans. A 2011 study found that only 1 in 1,000 student loan borrowers that filed bankruptcy tried to have their student loans written off and succeeded at a rate of only 40%. Apparently it’s an “undue hardship” to prove “undue hardship”. Maybe because Section 523 of the Bankruptcy Code does not set out a specific test to determine what qualifies as undue hardship. The federal courts are split on how to set the appropriate standard for discharging student loan debt.
So what’s the deal with this new proposed law to allow bankruptcy for student loans?
If passed, FRESH START through Bankruptcy Act would remove the lifetime ban on student loan discharge in bankruptcy and replace it with a 10-year ban. If borrowers can show, according to this new law, that paying their student loans caused “undue hardship” during the first 10 years, they can get it discharged after that 10-year period is over without having to prove that it would be an undue hardship from that point forward. This would only apply to federal, not private student loans. Any discharge of private student loans, regardless of the repayment timeline, would still fall under the current requirement to prove undue hardship.
To help carry some of the cost to the federal government should this pass, the bill includes an accountability measure for schools. The college or university would have to reimburse the government for a portion (50%, 30% or 20%) of the discharged student loan amount depending on several factors.
Would bankruptcy become a good way to get rid of student loans?
Declaring bankruptcy is never the first choice for anyone for any debt, but to have the option available to help with student loans that have become SO burdensome to thousands of borrowers would be a good option.
Currently you can enroll in an income-driven repayment plan, such as Revised Pay As You Earn. These limit the amount of the payment on federal student loans to a % of your discretionary income (the difference between your income and 150% of the state poverty guideline, adjusted for family size).
After 20 years of repayment for undergraduate loans (only 10 years if the borrower is in a public service job), the remaining balance is forgiven. But wow. It’s too bad they didn’t address the erroneous way that interest is applied to these loans! Most could pay off what they borrowed but when you have to pay back double if not triple what you borrowed – how does that NOT create an undue hardship?! Some people will become grandparents before their student loans are considered paid off.
If the new bill becomes law, borrowers will have a choice. They can either pursue bankruptcy after 10 years, or continue trying to pay until loan forgiveness becomes an option.