Can Student Loans Be Discharged in Bankruptcy?
Bankruptcy is often the final, last resort for those in dire financial straits; a way out to clear out unbearable debts you can’t afford to pay. A struggling company may file for bankruptcy with the hopes of reorganizing their debt in order to prevent going out of business. Individuals suffering from debt -- be it medical bills, underwater loans, credit card or gambling debts -- may seek bankruptcy for forgiveness from their creditors, to start a clean slate.
Insurmountable student loan debt may also lead some people to declare bankruptcy, too. Unfortunately, it's a desperate move contemplated by borrowers and college grads.
If you feel debt has gotten the better of you, student loans can be discharged in bankruptcy. It’s not easy, with some special rules to follow in order to qualify. But, if you meet the standards, you won’t need to worry about your debts any longer. Is bankruptcy right for you, however? It all depends on how you file, if you qualify, and weighing the potential costs and impacts to your finances if you’re considering it.
Two Types of Bankruptcy
Two of the most common types of bankruptcy are Chapter 7 bankruptcy and Chapter 13 bankruptcy.
Student Loans in Chapter 7 Bankruptcy
Two of the most common types of bankruptcy are Chapter 7 bankruptcy and Chapter 13 bankruptcy.
Chapter 7 is what’s called a liquidation bankruptcy. It’s meant to liquidate or erase all your unsecured debts. Declare Chapter 7 bankruptcy, and you have no more obligation for your remaining debt.
In an ideal case, filing for Chapter 7 would absolve you of the most, if not all, of the rest of your debt, no matter how much remains of your student loan balance. You’d owe no more of your balance and no more interest on any federal and private loans. Your debt is wiped out, gone, and you don’t have to pay back anything. At the very least, your debt obligation would be significantly reduced.
Student Loans in Chapter 13 Bankruptcy
Unlike Chapter 7 bankruptcy, Chapter 13 bankruptcy is known as a reorganization bankruptcy. It’s similar to how you’d consolidate your loans or enroll in a loan repayment program; if you qualify and get approved for Chapter 13, your debts are reorganized to make paying them back easier.
Chapter 13 is ideal for people who earn a regular, stable income who can afford to pay back at least a segment of their debt. For student loans, you may find more flexibility. Depending on the terms of your settlement, you may be allowed to pay back a portion of your debt in an agreed-upon payment plan, and in some cases, your debt may be discharged like it would in a Chapter 7 bankruptcy.
Student Loans in Chapter 7 Bankruptcy vs. Chapter 13 Bankruptcy
|Chapter 7||Chapter 13|
|You have little to no income to pay off your debt (and you're able to prove it)||You have a fair amount of income that allows you to pay off some of your debt|
|Most if not all of your debt will be erased and there will be no repayment plan||Your debt is restructured - so a repayment plan will be set up to suit your disposable income|
|Process to absolve debt could take 3 - 5 months||Agreed upon repayment plan could last 3 - 5 years|
Student loans aren’t automatically discharged in bankruptcy, and getting your debt removed through Chapter 7 or 13 can be a difficult and lengthy process. In both instances, but especially for Chapter 7, you’ll need to prove an undue financial hardship exception.
Examples of successful student loan discharge in bankruptcy:
- A college-educated married couple was able to show proof of undue hardship and had student loans discharged. They had low-paying jobs that barely put them above the poverty level. The court ruling resulted from the acknowledgment of their good faith effort and frugal budget that still led to a net cash flow of negative $400 per month.
- A 50-year-old student loan borrower earning about $8.50 per hour as a telemarketer was granted a discharge. The court found that the borrower had reached maximum earning potential and could not earn enough to pay the loans and support minimal family expenses.
- A number of courts have granted discharges in cases where the borrower did not benefit from the education or went to a fraudulent school.
That means you must be able to legally claim that you can’t afford to repay your student loans under any circumstances -- that it would impose an undue hardship on you financially. Evidence from around the web suggests that less than 1% of private student loan borrowers in bankruptcy actually attempt to use undue hardship as a proof for discharge and that less than half of that one-percent are successful in receiving even a partial discharge.
Proving undue hardship can be mightily hard to convince that to a court, mostly because, according to the U.S. Department of Education, the court system doesn’t utilize only one factor to determine undue hardship, but a series of considerations to decide if you qualify for bankruptcy.
If you're able to successfully file your student loans under your bankruptcy, you are able to discharge both your federal loans and your private loans. Just remember, everyone's personal situation may differ and finalized decisions about your student loans will be deemed in court.
When you request your student loans for discharge through bankruptcy, the first step is to speak with a bankruptcy lawyer that will help you through the process.
1. Filing a Complaint to Determine Dischargeability
This will start the process that leads up to an adversary proceeding. It’s technically a lawsuit but closely related to the bankruptcy proceedings.
Studies have shown that about 40 percent of people who filed for an adversary proceeding are able to discharge most, if not all, of their student debt. However, discouraged early on that the odds of winning chapter 7 for student loans are slim, one-tenth of petitioners don’t bother filing the complaint. Filing the complaint, and if possible, having an attorney skilled in bankruptcy at your side can improve your odds of getting your debt discharged.
2. Assessment tests
Bankruptcy courts primarily utilize two assessment tests to determine if repaying your student loans is an undue hardship: the Brunner Test and the totality of the circumstances test.
Under the Brunner Test, you’ll need to meet three legal standards to establish undue hardship:
- Your existing income and expenses places you in poverty, that if you’re forced to repay your student loans, you’ll be unable to maintain a minimal standard of living for yourself and your dependents;
- Your current financial situation will likely persist for the foreseeable future, and is unlikely to improve, at least for the majority of your student loan’s repayment period; and
- You’ve exhausted every good faith effort to repay your loans to no avail.
In addition to the Brunner test, some bankruptcy courts may prefer to utilize the totality of the circumstances test. In order to qualify for bankruptcy under the totality of the circumstances test, you must demonstrate that your complete, total financial circumstances would create an undue hardship for repaying your loans. Some factors the courts take into consideration are:
- Your prior, current and future income
- Your current and future living expenses
- Other details and facts that are relevant to your financial status
After you've proved undue hardship
So you successfully fell into that fraction of a percent that were able to get their student loans filed under their bankruptcy, congrats! Actual decisions will be presided over in court, but you can expect that your loans will either be partially discharged, fully discharged, or restructured. If your student loans become restructured in court, you’ll receive new payment obligations that will better fit your financial situation.
Bankruptcy and Its Impact on Your Credit
Caring about your credit score is important, since it’s more than just a number; those three digits are a numerical representation of your financial health, and reflect either how weak or how strong your credit is -- how timely you pay your bills, how diversified your credit is, the length of time you’ve had credit, the amount of credit you have, plus more.
Thus, any negative financial incident can severely impact your credit score in a negative way. Late bill payments, delinquencies, defaulted loans and bills sent to collections will all leave poor marks to your credit report and score.
Bankruptcies, unfortunately, are the worst. They indicate you were unable to resolve your financial issues on your own and needed a legal bailout to set your finances straight. A single bankruptcy can set back your FICO score 160 to 220 points.
If your credit score was average to begin with, a bankruptcy can cause it to plummet even further, making it harder to qualify for low-interest loans or credit. Come too close to the poor-to-bad credit range (approximately 300 and below), and it becomes more challenging to be approved for any loans at all.
And if your credit was at one point very good to excellent, a single Chapter 7 or 13 filing can injure (albeit temporarily) an otherwise stellar credit record. And the consequences can linger. While debts discharged in bankruptcy stay on your credit report up to about 7 years, the bankruptcy itself can also remain listed on your history for Chapter 13 bankruptcies, and for Chapter 7, up to 10 years. (Based on the nature of the bankruptcy.)
Alternatives to Consider First
Is filing bankruptcy to discharge your student loan debt ultimately a good idea? Bankruptcy can hurt your credit profile the most and should always be your last resort after you’ve exhausted every possible debt solution option available to you:
Federal student loan deferment allows you to defer, to put your loan payments on hold, for up to three years. Depending on the loan, such as for Perkins Loans, Direct Subsidized or Direct Stafford Loans, your interest may be paid by the U.S. government during the principal payment delay period.
Forbearance is also a delay in your payments for up to one year, during which time you won’t owe any money. Interest will continue to accrue, however, meaning you’ll owe more after the forbearance period is complete. Will one year be enough time to get your money situation in order?
Income-based repayment is a series of payment plans offered by the Department of Education. If you can’t afford to make your payments under the standard payment, IBR may be the solution for you because it bases the monthly amount you owe on your income, not your loan balance.
IBR plans include Pay as you Earn (PAYE), Revised Pay as you Earn (REPAYE) and Income-Contingent Repayment (ICR).
Using a personal loan to refinance your student loan debt can help you save money on interest. By taking out a personal loan with a lower interest rate than your student loans, you can consolidate and combine several student loans into one personal loan payment.
What are some of the benefits? Loan amounts range from $1,000 to about $100,000. Personal loans give you the chance to lock into lower, fixed interest rates, plus faster repayment periods. And if bankruptcy still becomes the route you take, personal loans are more easily discharged than student loans.
Balance transfer credit cards
With a balance transfer, you can transfer your student loan debt to a credit card with a lower interest rate.
Example: you have $37,000 in several student loans (the average amount for recent grads), with interest rate ranging from 5 to 7 percent. You open a balance transfer credit card with an introductory interest-free period, say 18 months, and transfer your student loan debt to the card. With 0 percent interest, now you have the chance to make payments only to your principal balance without interest getting in the way.
Check the terms and conditions of a balance transfer credit card before opening one. Many cards require you to pay off your entire debt balance during the introductory 0% APR period. This may not be enough time and could end up worsening your debt situation.
Bankruptcy isn’t something to be taken lightly. It can be a protracted ordeal that may end up costing you more money when attorney and court fees are taken into consideration. It’ll rid you of your debt, but leave negative marks on your credit report that will take years to disappear -- and during those years, having had a bankruptcy can make it difficult to obtain other loans or credit.
If you feel bankruptcy is your only option, pursue it with your full attention and dedication, with the goal to eliminate your debt completely. But remember that you do have plenty of other options to consider first that are kinder to your credit, and allow you to take control of how you manage your student loans. Always treat bankruptcy as a final, last resort.