Student Loan Bankruptcy

Student Loan Bankruptcy

If you have student loans and file for bankruptcy, it may discharge your loans. Discharged loans are canceled, or ‘wiped out’. According to Lendedu, 32% of consumers filing for Chapter 7 Bankruptcy also carry student loan debt. Of this group, student loan debt make up about 49% of their total debt.

The point of filing Chapter 7 bankruptcy is to get a fresh financial slate. That said, many students have more debt than assets. So, it is unlikely you will be able to wipe out your total student loan debt with a Chapter 7 bankruptcy.  For one-third of Chapter 7 filers, 50% of their debt will remain.

What is the difference between Chapter 7 and Chapter 13 bankruptcy?

Chapter 7 and Chapter 13 are part of the US Bankruptcy Code. Both offer the potential to free you from student loan debt. But they tend to be for different people and types of loans.

Chapter 7 Bankruptcy

A Chapter 7 Bankruptcy is a straight bankruptcy. You may qualify as a person, partnership, company or business entity.

If you are eligible to file a petition, the court appoints a Trustee. And this person sells off your assets (E.g. house) to pay your creditors. Some assets are exempt, but anything that isn’t is sold. If your bankruptcy is successful, you get a discharge notice that releases you from your debt.

Chapter 13 Bankruptcy

A Chapter 13 Bankruptcy is also a wage earner’s plan. You may be eligible to file one if you are self employed or run an unincorporated business. In other words, you need to get a regular salary.

If you qualify, you agree to make a ‘payment plan’ to repay your creditors. So, in contrast to a Chapter 7, you don’t have to sell your assets. The installments tend to span a period of three to five years. At the end of your plan, you get a notice that forgives your remaining unpaid debts.

What are the Pros and Cons of Student Loans?

Student loan bankruptcy may be either a Chapter 7 or Chapter 13. On average, student loan debt makes up 43% of consumer’s debt. Another 24% of debt is ‘uncategorized’ or ‘unsecured’. Unsecured debt comes from medical bills, credit card debts and personal loans, and mortgage.

In a Chapter 7, you are trying to get all unsecured debts discharged. That said, student loans may be so high that not all this debt goes away with a Chapter 7. So even if you win your petition, it may not change the fact you have debt. Even while it would lower the amount you owe.

In contrast, for a Chapter 13 you are trying to reorganize the debt into affordable payments. It could be a useful option if you have debts not eligible for relief. Also, your income level may disqualify you from declaring Chapter 7 bankruptcy. In this case, if you can afford to pay some of your debt, Chapter 13 may be your only option.

How to Prove Undue Hardship When Paying Back your Student Loans

Undue hardship is a term defined by the courts. It means that if you continue your loan payments, you won't be able to meet basic standards of living. Debtors can prove undue hardship through the Brunner test and Totality of Circumstances test.

Each jurisdiction may use a different method to test undue hardship. You should speak with a local bankruptcy lawyer to find out what you have to prove.

Brunner Test

Courts tend to use a standard called the “Brunner test” to prove undue hardship. The Brunner test uses three metrics:

  1. Poverty. This metric looks at your current income and expenses for you and your dependents. Then assesses if you have enough money to keep a minimal standard of living and repay your loan.
  2. Persistance. A test to see if your current financial situation is likely to continue for a major part of the loan repayment period.
  3. Good faith. To see if you have made every possible effort to pay back your student loan.If you do meet all three benchmarks, it may discharge federal and private student loans.

If you do meet all three benchmarks, it may discharge federal and private student loans.

Totality of Circumstances Test

Some courts may use the “Totality of Circumstances Test”. The courts will focus on all the circumstances of a particular case, rather than any one factor.  

What are the Alternatives to Declaring Bankruptcy?

Declaring a bankruptcy may be in your favor if you succeed at proving undue hardship. However, there are a few reasons to try and avoid bankruptcy. First, there are many procedural steps involved with filing with bankruptcy. As a result, you will need to hire a lawyer which can be quite expensive for a student.

Also, a bankruptcy may affect your credit score for years to come. According to FICO, filing for bankruptcy can remain on your credit history for 7 to 10 years. For instance, it remains on your credit history for seven years for a completed Chapter 13 bankruptcies.

How to Avoid Bankruptcy if you are a College Student?

One way to avoid declaring bankruptcy is to be proactive. Here are a few tips on how you can avoid it.

  1. Know when your payments begin and put the schedule on your calendar.
  2. Make a call to your loan servicer if you struggle to meet your loan payment.
  3. Set up a budget. Try not to rack up other debt.
  4. Check your student loan account often to see if all details are accurate.
  5. If you switch banks, change home address or make other changes, make sure your loan servicer knows.
  6. If your loan repayment plan does not adapt to your needs, find out if there are options.
  7. Watch to see if your loan servicer changes over time and if the terms you signed up for still apply.

Loan Consolidation

You may be able to consolidate federal student loans. This rolls them into a single loan with one monthly bill and fixed interest. However, it could also extend the time it takes to repay them. FYI, the federal gov’t will NOT ask for a fee to consolidate your loans so be aware of scam loan providers. 

Refinance Private Loans

One cannot consolidate private loans in the federal Direct Consolidation Loan program. So if you consolidate student loans through private lenders, you refinancing your them. If this lowers your interest rate and monthly payments, it may be worth checking into.

Public Service Loan Forgiveness

Do you work for a U.S. federal, state, local, or tribal government or not-for-profit? If so, you might be eligible for the Public Service Loan Forgiveness Program. The PSLF Program forgives the remaining balance on your Direct Loans. The requirement is you need to make 120 qualifying monthly payments under a qualifying repayment plan while working full-time for a qualifying employer.

Student Loan Forbearance

Forbearance suspends or reduces your monthly loan payments. It is a temporary remedy that lasts for a specific time. Your lender may grant this to you if you are willing but not able to make loan payments. And tends to be for certain types of financial hardships (E.g. illness). If you get one, it postpones your payments but not the interests. So this interest gets added onto your balance, and increases the amount you owe.

Income Driven Repayment Plans

Let’s say your federal student loans are high compared to your income. It may be in your favor to repay your loans with an income driven repayment plan. Most federal student loans are eligible for at least one (there are four) IDR plan. If your income is low enough your payment could be as low as $0 per month. In general, your payment plan under an IDR is a % of your discretionary income.

 

Type of Income Driven Payment PlanPayment (% Discretionary Income)
Revised Pay As You Earn Repayment Plan (REPAYE Plan) In general, 10%

Pay As You Earn Repayment Plan (PAYE Plan)

In general, 10% but never more than the 10 year Standard Repayment Plan amount
Income Based Repayment Plan (IBR Plan)

Tends to be 10% if you're a new borrower on or after July 1, 2014*, but never more than the 10 year Standard Repayment Plan amount

Or, 15% if you're not a new borrower on or after July 1, 2014, but never more than the 10 year Standard Repayment Plan amount

Income Contingent Repayment Plan (ICR Plan)

Whichever is lower. Either 20% of your discretionary income OR what you would pay on a repayment plan with a fixed payment over the course of 12 years, adjusted according to your income

*Source: Federal Student Aid