Student Loans & Bankruptcy
Student loans have a long and tortured relationship with bankruptcy.
A BRIEF AND SAD HISTORY OF STUDENT LOAN DISCHARGEABILITY
Prior to 1976 – Student loans could be discharged like other unsecured debts and borrowing and repayment were subject to normal market forces like any other debt.
1976 – Federal Regulations held that student loans could not be discharged unless they had been in repayment for 5 years prior to the filing of the bankruptcy; if the student loans had been in repayment for less than 5 years, they could only be discharged if it was an “undue hardship” for the borrower to repay the loan. In 1978, the Bankruptcy Code was amended to contain the same restriction.
1979 – The 5-year repayment period requirement was extended by any deferments and forbearances that had been taken by the borrower. This limitation on dischargeability was expanded beyond loans made by a government unit to loans insured, guaranteed or funded by a government unit.
1981 – The 8th circuit (which includes Minnesota) established a test for undue hardship taking into consideration the “totality of circumstances” to determine dischargeability.
1984 – The 5-year repayment period requirement was again expanded to include private loans made under “any program funded in whole or in part by a nonprofit institution.”
1987 – The Brunner test (used by the 2nd, 3rd, 4th, 5th, 6th, 7th, 9th, 10th and 11th Circuits) established the use of a three-prong test to show an “undue hardship” for student loans in repayment for less than 5 years. Some courts refer to this test as requiring a “certitude of hopelessness.”
1990 – The Bankruptcy Code extended the repayment period requirement from 5 years to 7 years.
1991 – The statute of limitations no longer applied to student loans.
1998 – The Bankruptcy Code was amended by Congress to remove the 7-year repayment period requirement, thereafter only allowing student loans to be discharged after a showing of “undue hardship.” This requires that a debtor bring an adversary proceeding (file a lawsuit against the debtor’s student loan lenders in bankruptcy court) after discharge to determine if the student loan is dischargeable.
2005 – The Bankruptcy Code is amended to expand the definition of a student loan to include almost all public and private loans. There have been few changes to student loan dischargeability requirements since 2005. The “totality of the circumstances” and “Brunner” tests remain high hurdles which effectively prevent discharge of student loans except in the most extreme cases of hardship.
These changes in bankruptcy law over the past several decades have effectively removed all market forces from the student loan lending industry. This has skewed the student loan market heavily in favor of lenders, leading to disastrously negative consequences for student loan borrowers:
- Lenders have no incentive to select or reject borrowers based on their likelihood of paying back their student loan debt. If the borrower does pay back student loans, then the lender makes profit on the interest paid. If the borrower does not pay back their student loans, then penalties and interest accrue, and the lender can pursue the borrower essentially forever. And if the loan is a federal student loan, then the federal government can step in to take unique actions such as capturing tax refunds and garnishing wages without a judgment. The result is an open spigot of money flowing from lenders to borrowers.
- The free flow of student loans has encouraged educational institutions to compete for students’ seemingly limitless supplies of student loan money with ever-expanding amenities and bloated administration. This has driven up fees and costs, requiring students to incur more debt. This unvirtuous cycle continues without disincentive to responsibly control costs.
- This feedback loop has swelled the outstanding student loan debt in this country to an estimated 1.5 trillion dollars, with an estimated 11.4% in default at any given time.
Although most politicians pay some lip service to the “student loan crisis,” there has been virtually no action on this front in many years. Unfortunately, student loan borrowers are dependent on congress to take action and provide relief from a seemingly ever-increasing student loan burden.