Impact of Bankruptcy Law on Student Debt
Background: The discharge of government guaranteed or issued student debt has always been extremely difficult and rare. Most courts require that the borrower show a “certainty of hopelessness” for his or her financial situation over the repayment term of the loan. An August 31, 2012, New York Times article describing the petition of a legally blind, unemployed man illustrated the hurdles a student loan borrower must clear in order to have student debt discharged in bankruptcy.
The enactment of the 2005 bankruptcy reform law severely reduced rights of all debtors in bankruptcy. The most documented aspect of the new law was to make it much more difficult for debtors to obtain a chapter 7 bankruptcy and immediately get unsecured loans discharged. Other procedures imposed additional hardships on people with student debt.
Prior to the enactment of the 2005 bankruptcy law private student loans were dischargeable in bankruptcy. The 2005 bankruptcy law changed this rule and made it very difficult to discharge private student loans in bankruptcy.
Note the discharge of private student loans in bankruptcy does not adversely impact taxpayers. In fact, the discharge of private student loans in bankruptcy should free funds for debtors and accelerate the repayment of guaranteed student loans in bankruptcy.
Financial outcomes of borrowers in bankruptcy are also affected by the rules governing whether a debtor can obtain a Chapter 7 bankruptcy or a Chapter 13 bankruptcy.
Student debts are not forgiven in chapter 7. Student debt does not generally have priority over consumer debt in most Chapter 13 repayment plans. Student loan borrowers in Chapter 13 can petition the bankruptcy court to allocate a greater amount of their payment plan to the repayment of student loans and a lower amount to the repayment of other unsecured credit card debt. However, most courts tend to favor a payment plan that does not discriminate against any class of unsecured creditors. As a result, many student loan debtors emerge from the bankruptcy process five years older with a substantial amount of unpaid student loans. Many individuals experience decreases in income and have fewer job prospects after age 50. A delay in repayment of student loans caused by a forced entry into a Chapter 7 bankruptcy plan will increase financial exposure to taxpayers, increase student loan default rates, and decrease collection rates.
Potential changes to the bankruptcy code that would benefit over-extended student borrowers:
There are four potential changes to bankruptcy law, which could assist over-extended student borrowers.
First, the law could be modified to make it easier for debtors to obtain immediate debt relief under chapter 7 rather than file a payment plan under chapter 13. The immediate discharge of consumer would free up funds that could be used for the repayment of student debt. However, the borrower after leaving bankruptcy could incur new debt and forego student loan payments.
Second, the rules governing payment plans in chapter 13 could be modified to give student deb priority over consumer loans. A revision of Chapter 13 bankruptcy rules that gives priority to student debt payments over other unsecured debt payments in bankruptcy would provide student loan debtors with a fresh financial start and would ultimately reduce taxpayer losses. Unsecured creditors would still enjoy greater collection rights than existed prior to the 2005 bankruptcy law. This change would also benefit taxpayers guaranteeing student debt repayment,
Third, bankruptcy law should be changed so that private student loans are dischargeable in bankruptcy. Many private student loans have high interest rates and have more in common with consumer debt than traditional student loans. The restriction on the discharging of private student debt in bankruptcy does not provide clear direct benefits to taxpayers.
Fourth, whether a private student loan is dischargeable or not in bankruptcy could become contingent on the characteristics of the loan. Many private student loans have characteristics closer to high-risk high-fee consumer debt than they do with government guaranteed student debt. Private student loans with high fees and high rates should be classified as consumer debt not student loans for their treatment in bankruptcy. Moreover, unless private student loans can be consolidated in the IBR program they should not be dischargeable in bankruptcy.
Concluding Thoughts: The 2005 bankruptcy law imposed substantial hardships on many households. It was enacted shortly before the collapse of the housing market and financial systems. The law, by reducing forgiveness of student debt caused many borrowers to default on their mortgage.
Today the lack of relief on consumer loans in bankruptcy, the treatment of private student loans in bankruptcy, and the rules governing chapter 13 repayment plans have made it more difficult for borrowers to repay student debt.
The changes to the bankruptcy code would benefit both student debtors and taxpayers, guaranteeing student debt.
Next Up: Debt relief is a last resort. We all prefer to lower the amount of debt incurred. Students who graduate on time incur less debt. The next post discusses policies to improve on-time graduation rates.
Proposal Six: Improving On-Time Graduation Rates