More than 44 million Americans have student loans, owing a collective $1.5 trillion (yep, with a “t”). And if the sheer amount of student debt our country faces isn’t scary enough, about 1 million borrowers go into default every year. That means they haven’t made a payment for about a year and the debt has been sent to collections.
Usually, when people have so much debt that it becomes unmanageable, bankruptcy is a last-resort option they can pursue. Though the effect on their credit can be devastating, they may decide it’s worth it if it means finally getting some breathing room.
But when it comes to student loan debt, that’s a different story. In fact, many claim it’s impossible to discharge student loans in bankruptcy.
We spoke with Adam Minsky, a lawyer in Boston with a practice dedicated solely to helping student loan borrowers, to find out if that’s really true.
Why is discharging student loans in bankruptcy so difficult?
“Congress carved out a specific exemption in the bankruptcy code that treats student loans differently than any other type of consumer debt,” Minsky said.
That exemption, passed in 2005, is known as the Bankruptcy Abuse Prevention and Consumer Protection Act, which applies to all federal and private student loans. Unless the borrower can prove they face undue hardship as a result of their student loan debt, those loans are exempt from discharge when filing for bankruptcy.
“The other problem is that Congress didn’t really define this term ‘undue hardship,’” Minsky said. “And whenever Congress passes a law that doesn’t define a term, it’s really up to the courts to interpret what that term means.”
Defining ‘Undue Hardship’
How the vague standard of undue hardship is defined varies from court to court. “There’s no one set of factors that courts will look at,” Minsky said. “Courts use a couple different tests, depending on what circuit you’re in.”
However, one of the early cases to interpret that term was the Brunner case, which set the standard for what undue hardship means. According to Minsky, in most circuits, courts will use the Brunner test, which requires borrowers to demonstrate the following:
They cannot maintain, based on current income and expenses, a minimal standard of living for the debtor and dependents if forced to repay the student loans.
Additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period of the student loans.
They have made good-faith efforts to repay the loans.
Essentially, Minsky explained that the court must evaluate the borrower’s past, current and future circumstances to try to figure out whether or not they meet the standard. Minsky noted that the court will consider factors such as the borrower’s age, health, job history and income, age of the loans, payment history and other exceptional circumstances, such as a sick family member who requires a lot of care.
Clearly, there’s quite a bit of subjectivity that goes into a court’s decision.
“There’s precedent that judges have to follow, but you can certainly get a different outcome depending on the court,” Minsky said, which he pointed out is true in any type of legal matter. “Ultimately, it’s a lot of speculation.”
For instance, it’s impossible to predict for sure what the future holds for a particular borrower. And yet that’s a major part of the court’s evaluation.
Federal Vs. Private Student Loans
Another potential snag for borrowers pursuing bankruptcy is if they have federal loans.
Both federal and private student loans are treated the same under the bankruptcy code, and both are subject to the same undue hardship standard. However, according to Minsky, the difference is that federal loans have income-driven repayment options, which can lower payments to a small percentage of the borrower’s income. In some cases, that payment can be as low as $0.
“That is being used by the Department of Education and federal guaranty agencies as a reason for arguing that a borrower doesn’t meet the standard,” Minsky said. “The argument is, ‘well, you can get onto an affordable payment plan, so how can it possibly be an undue hardship?’ So it’s not that they’re treated differently under the law, it’s that there could be different arguments used depending on those specifics.”
Even so, federal loans aren’t necessarily a deal-breaker. Minsky said there’s still the administrative burden of having to recertify your information each year. Plus, income-driven payment options promise to end in loan forgiveness after 20-25 years of payments, depending on the program, and there are tax consequences to that. Any forgiven debt is taxed as income for the year, which could be too large a bill for a struggling borrower to handle.
Is filing bankruptcy for student loans ever a good idea?
Minsky explained that filing for bankruptcy requires something called an adversary proceeding. “It’s basically a fancy term for suing your student loan lenders in bankruptcy court,” he said. That means going through the litigation process, which could be long, draining and expensive.
For that reason, it doesn’t always pay to pursue bankruptcy, especially if the borrower has alternative options for stopping a lawsuit, getting out of default or getting onto a loan repayment program. “Bankruptcy is usually the option to consider when there are no other options, in which case, even with the chances being so tough, it could be worth exploring,” Minsky said.
Filing for bankruptcy on student loans might be costly and time-consuming, but one thing is for certain: It’s not impossible.
“It becomes this self-fulfilling prophecy where people don’t go for it because they think it’s not viable or it’s not an option at all,” Minsky said. “And so few people go for it, which reinforces the notion that it is extremely unlikely or impossible.”
In fact, a 2011 study by Jason Iuliano of the University of Pennsylvania Law School found that close to 40 percent of borrowers who included their student loans in their bankruptcy filings got a portion or all of that debt discharged. However, only 0.1 percent of people who filed for bankruptcy actually tried to discharge their student loans.
The study also found that those who were successful tended to share three qualities: They were unemployed, had a medical hardship and had lower annual incomes the year before they filed for bankruptcy.
Bankruptcy isn’t a silver bullet by any means. If you have another option for getting your student loan payments down to an affordable level, take it. If you’re out of options, bankruptcy can be a last resort.
“It is not easy and it is not always going to be cheap, but it is far from impossible. And for some people, I think it is a viable option to pursue,” Minsky said.