How to Discharge Your Student Loans in Bankruptcy
Discharging student loans in bankruptcy is difficult, very difficult, but not impossible. Some borrowers have succeeded in getting their student loans discharged in bankruptcy. There are several steps that borrowers should take if they wish to obtain a bankruptcy discharge for their student loans.
Bankruptcy Discharge of Student Loans Is Very Rare
You can’t simply wave a magic wand, announce to the world “I declare bankruptcy” and watch your student loans disappear. It isn’t that easy.
In a 1981 bankruptcy court case, Judge Burton R. Lifland said that discharging student loans required “a certainty of hopelessness, not simply a present inability to fulfill the financial commitment.”
It is much easier to wipe away credit card debt, personal loans, auto loans and mortgages than student loans. The U.S. Bankruptcy Code puts student loans in the same category as child support obligations, taxes and criminal fines.
Statistics concerning the rarity of bankruptcy discharge for student loans are based on information provided by the Educational Credit Management Corporation (ECMC). ECMC is the guarantee agency that services defaulted federal student loans when the borrower files for a bankruptcy discharge.
Only 29 of 72,000 student loan borrowers with active bankruptcy filings in 2008 succeeded in getting a full or partial discharge of their student loans, according to ECMC.
That’s 0.04%, or odds of about 1 in 2,500. You’re more likely to die of a heart attack or of cancer than to get your student loans discharged in bankruptcy. Still, the odds of discharging student loans in bankruptcy are better than your odds of winning the Powerball lottery jackpot.
Nevertheless, these low odds are due, in part, to very few borrowers including their student loans in their bankruptcy filing. Also, it is unclear if the ECMC statistics are limited to just federal student loans. Federal student loans are much more difficult to discharge in bankruptcy than private student loans because federal student loans offer income-driven repayment plans.
Bankruptcy Discharge of Student Loans Requires Undue Hardship
Qualified education loans, which include all federal education loans and many private student loans, cannot be discharged in bankruptcy unless this would “impose an undue hardship on the debtor and the debtor’s dependents” [11 USC 523(a)(8)]. Loans made under a program that is funded in whole or in part by a nonprofit institution are similarly excepted from discharge.
Congress did not define what it meant by the term undue hardship. Since most bankruptcy court cases involve financial hardship, it seems that Congress wanted a harsher standard for student loans, one that presents an unreasonable or excessive burden. But, Congress left it to the bankruptcy courts to define the term.
Originally, Congress allowed student loans to be discharged if they have been in repayment for at least five years. Undue hardship was provided as an alternative for discharging student loans that had been in repayment for a shorter period of time. The option for a bankruptcy discharge after five years was increased to seven years in 1990 and eliminated entirely in 1998, leaving just the undue hardship option.
Most courts have adopted one of two standards for defining undue hardship, either the Brunner Test (all circuits but 1st and 8th) or the Totality of Circumstances Test (8th circuit).
The Brunner Test involves three prongs:
- You must currently be unable to repay the student loans and maintain a minimal standard of living for yourself and your dependents.
- The circumstances that prevent you from repaying the student loans must be likely to continue for most of the repayment term of the loans.
- You must have made a good faith effort to repay the student loans, including using options for financial relief, such as deferments, forbearances and income-driven repayment.
The Totality of Circumstances Test omits the third prong of the Brunner Test and is more flexible.
In addition, the borrower must file the undue hardship petition in an adversarial proceeding, where the lender can challenge the claim of undue hardship.
Get an Attorney
A borrower is more likely to obtain a bankruptcy discharge of their student loans if they are represented by an experienced attorney.
However, most bankruptcy attorneys are unwilling to pursue an undue hardship claim because these cases involve an adversarial proceeding, which are expensive and involve a lot more work. It can cost $10,000 or more to pursue an adversarial proceeding and borrowers who file for bankruptcy usually don’t have the money to pay the lawyer’s fees. Lenders are also likely to appeal the decision, so a favorable decision is unlikely to be final.
Even if you don’t have an attorney and are representing yourself pro se, always show up in court. If you don’t show up when required, the lender can win the case by default.
Demand Proof that the Debt Is Owing
In any court case involving student loans, demand proof that the debt is owed. In particular, ask for a copy of the signed promissory note, especially if the loan has been sold.
The lender may not have the original loan promissory note or a copy. If so, they will have difficulty proving that the borrower owes the money or that they hold title to the debt.
Spreadsheets showing a history of loan payments are business records and are not proof that the debt is owed.
Generally, courts show a lot of deference to lenders. Many will allow the lender to provide a copy of the promissory note that was in use at the time and proof that the borrower received or benefited from the loan proceeds in lieu of the borrower’s actual signed promissory note.
But, if there is any evidence that suggests that you did not borrow the loan, present it and challenge the veracity of the lender’s proof. For example, compare the signature on the promissory note with your actual signature and present the court with copies of your signature on other documents. If you were incarcerated at the time the loan was supposedly borrowed, present the court with documentation of this, since incarcerated individuals are ineligible for federal student loans.
Question Whether the Loans Are Qualified Education Loans
If a loan is not a qualified education loan, it may be dischargeable in bankruptcy without requiring an undue hardship petition and adversarial proceeding. You should challenge whether the loan satisfies the requirements to be considered a qualified education loan.
Qualified education loans must have been borrowed solely to pay for qualified higher education expenses of an eligible student who was enrolled on at least a half-time basis and seeking a degree, certificate or other recognized education credential at an eligible institution of higher education.
A refinance of a qualified education loan is also considered a qualified education loan.
There are several types of loans that are not qualified education loans:
- Mixed-use loans, such as credit cards, personal loans, auto loans, home equity loans, HELOCs and cash-out refinance of a mortgage, are not qualified education loans because they were not borrowed solely to pay for qualified higher education expenses.
- Direct-to-consumer loans are not qualified higher education loans because they are designed to overcome restrictions on the amount borrowed and thus may exceed the college’s cost of attendance. Such loans are not school certified and therefore the college financial aid office cannot enforce a cost of attendance cap on the annual loan amount.
- Bar study loans are not qualified education loans because they are not used to pay for qualified higher education expenses. The borrower is also not an eligible student, since the student has already graduated.
- Residency and relocation loans are not qualified education loans for the same reasons as bar study loans.
- Continuing education loans and career training loans are not qualified education loans because the student is not enrolled on at least a half-time basis and is not seeking a degree or certificate.
- K-12 loans are not qualified education loans because they are not used to pay for qualified higher education expenses.
As these loans demonstrate, there are several characteristics of a loan, the student, the borrower or the educational institution that may prevent it from being considered a qualified education loan.
Criteria based on the characteristics of the loan or lender include:
- The loan may not be owed to a person who is related to the borrower, defined as a brother or sister (whether by whole or half-blood), spouse, ancestor or lineal descendant.
- The loan may not be a loan from qualified employer retirement plans, such as a 401(k) or 403(b).
- The loan must have been borrowed within a reasonable period of time (90 days) before or after the qualified higher education expenses are paid or incurred. Loans used to pay primarily for prior-year balances are not necessarily qualified education loans. Note that this timing requirement applies only to the original qualified education loan, not any subsequent refinance of the qualified education loan.
- The loan must have been borrowed to pay for the cost of attendance as defined in the Higher Education Act of 1965 as of August 4, 1997. This includes tuition and required fees, room and board, books, supplies and equipment, transportation, miscellaneous personal expenses, dependent care costs, study abroad costs, disability-related expenses and loan fees. It does not include room and board for students enrolled less than half time, the cost of obtaining professional licensure or certification, and the rental or purchase of a personal computer.
- If the lender received $600 or more in interest during the year and did not issue IRS Form 1098-E, the loan might not be considered a qualified education loan. Lenders of private student loans must also collect IRS Form W-9S from the borrower before issuing a 1098-E.
Criteria based on the characteristics of the student include:
- The loan must have been borrowed to pay for the education of a student who is enrolled on at least a half-time basis.
- The loan must have been borrowed to pay for the education of a student who is seeking a degree, certificate or other recognized educational credential.
- The loan must not have been borrowed to pay for the education of a dual enrollment student. A dual enrollment student is a student who is simultaneously enrolled in an elementary or secondary school in addition to a college or university.
Criteria based on the characteristics of the borrower include:
- The loan must have been borrowed by a U.S. taxpayer.
- The student must have been the borrower, the borrower’s spouse or a dependent of the borrower. For example, private parent loans are not considered qualified education loans if the borrower did not claim the student as a dependent. If the loan was borrowed by a grandparent, aunt or uncle of the student and the student was not claimed as a dependent, the loan is not a qualified education loan.
Criteria based on the characteristics of the educational institution include:
- The loan must have been borrowed to pay for the education of a student who is enrolled at an eligible educational institution. Eligible educational institutions are defined as Title IV colleges and universities. If the educational institution was not accredited or not eligible for U.S. federal student aid, the loan is not a qualified education loan.
Note that these criteria apply to the design of the loan, not necessarily to how the borrower chose to use the loan proceeds.
Demonstrate Undue Hardship
Demonstrating undue hardship often depends on the income and expenses of the borrower, as well as the borrower’s prospects for increasing income.
Several successful bankruptcy discharge cases have involved a severe disability that prevented the borrower from maintaining a minimal standard of living while repaying the loan, even with an income-driven repayment plan. Examples include:
- Disabled dependent. The borrower has a disabled dependent, such as a special needs child or elderly parent, with high ongoing cost of care. The borrower may be unable to work full-time while taking care of the disabled dependent. Although all federal student loans and some private student loans provide a disability discharge if the borrower is totally and permanently disabled, none provide a disability discharge if the borrower’s dependent is disabled.
- No disability discharge. Some private student loans do not provide a disability discharge. If the borrower is totally and permanently disabled, yet ineligible for a disability discharge, their medical and disability-related expenses may prevent them from maintaining a minimal standard of living while repaying the student loan debt.
- Low net income after subtracting disability expenses. Some disabled borrowers may be ineligible for a total and permanent disability discharge due to income above the poverty line for a family of two, yet still have insufficient income to repay their student loan debt. This can be because of high medical and disability-related expenses or because their family size is greater than two.
The borrower’s income may limit the borrower’s ability to repay the debt:
- Divorce or separation. The borrower’s income may be reduced by alimony and child support obligations.
- No prospects for increasing income. The borrower may be unable to get a better job because of age, infirmity, illness or disability. The borrower may already be earning the peak income for their occupation.
- Very low income. The borrower earns less than 100% or 150% of the poverty line for their family size. (Bankruptcy fee waivers apply to people with income below 150% of the poverty line for the family size.) The poverty line is often defined as the income level below which the family has no discretion in how it spends money to pay for necessary living expenses. Accordingly, low-income borrowers may satisfy the first prong of the Brunner Test.
- High cost of living. The borrower works in a city with a high cost of living, such as Boston, Manhattan or San Francisco.
- Predatory colleges. The borrower may have a useless degree that does not qualify the borrower for employment or to sit for a licensing exam. The borrower may have dropped out of college with debt but no degree.
The borrower’s debt may limit the borrower’s ability to repay the debt:
- Excessive debt. The borrower’s debt may be high enough to prevent the borrower from being able to repay the debt even if the borrower maximizes income and minimizes expenses.
- Lack of income-driven repayment. Private student loans do not offer income-driven repayment. Federal Parent PLUS loans are not eligible for income-driven repayment unless they are included in a federal direct consolidation loan, in which case the consolidation loan is eligible for income-contingent repayment.
Although deferments and forbearances are not permanent solutions for long-term financial difficulty, using these options may satisfy the third prong of the Brunner Test.
There may be other extenuating circumstances that affect the borrower’s finances.
Depending on the severity of the circumstances, the lender may seek to settle the bankruptcy case rather than set a legal precedent.
Alternatives to Bankruptcy for Student Loans
Before pursuing a bankruptcy discharge, consider alternative methods of dealing with financial distress:
- If your financial difficulty is short-term, consider using a deferment or forbearance.
- If your financial difficulty is long-term, consider switching to a different repayment plan, such as extended repayment or income-driven repayment. Extended repayment reduces the monthly payment by stretching out the repayment term. Income-driven repayment reduces the monthly loan payment by basing it on a percentage of your discretionary income, as opposed to the amount you owe.
- Look for loan forgiveness programs if you work in a public service occupation, like teaching, public health and the military. Look for employers who offer student loan repayment assistance programs.
- Consider refinancing the student loans into a loan with a lower interest rate.
- Contact the lender’s ombudsman to ask for a compassionate review.