Student Loan Bankruptcy Options

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Last Updated: Tuesday, 09 March 2021

When unemployment is high, students will have trouble finding jobs. Adding to this problem is the cost of a college education, and the enormous amount of debt students need to repay lenders. Unfortunately, the discharge of debt is extremely difficult for students under the current bankruptcy law.

Student Loan Discharge

Student loans are unsecured, meaning there is no collateral, such as a car, which can be repossessed to help repay the money owed. It's not possible to unlearn what has been taught, and no one can recapture a college diploma. But with the rising rate of bankruptcies in the United States, it was too "easy" to simply declare bankruptcy and have student loans discharged.

Bankruptcy Law Changes

Individuals can file for bankruptcy under two "chapters" of the code. Chapter 7 is known as liquidation, and involves the sale of all assets to help repay money owed creditors. Chapter 13 is known as reorganization, and involves creating a plan to repay creditors. In 2005, the bankruptcy law was updated. If the courts felt the filer had sufficient means of repaying lenders, a Chapter 7 liquidation case would be converted to a Chapter 13 repayment plan. In nearly all cases, student loans provided by the federal government were oftentimes exempt from discharge.

Hardship Rules

Borrowers do have the option of making a hardship request. After the initial bankruptcy proceedings are over, an adversary proceeding can take place in court to decide if the filer meets all three of the hardship rules or tests. In this adversary proceeding, the student loan creditors will be present to challenge the hardship request. Borrowers must be able to satisfy all three of the following tests in the eyes of the court:

• If forced to repay the student loan, the filer would not be able to maintain a minimal standard of living.
• There is evidence this financial hardship will continue for a significant period of time over the remaining term of the student loan.
• A good faith effort was made to repay the loan before filing for bankruptcy. Effectively, this means the borrower had been faithfully repaying the college loan for a minimum of five years.

Whenever a loan is discharged, the remainder of the money owed creditors does not have to be repaid. However, it may be nearly impossible to obtain a student loan of any kind in the future.

Repayment Relief

In addition to bankruptcy, there are actually five additional options former students have when seeking relief from their loans, including:

• Deferring Payment
• Forbearance
• Forgiveness
• Flexible Repayment Options
• Consolidation

Deferring a Student Loan

The first option borrowers have is called deferment. This process involves suspending, or deferring, the student loan payments for specified periods of time, and under specific conditions. For example, deferment might be possible due to unemployment, disability, or military service. This topic is discussed at length in our article: Student Loan Deferment.

Forbearance

Instead of declaring bankruptcy, there is another option known as forbearance. This is the temporary postponement of payments, or a reduction in payments, for a specific period of time. This arrangement is worked out with the lender, or creditor, and is in-effect until the financial difficulty is over.

Forgiveness Programs

Perhaps the most desirable of all alternatives to bankruptcy would be to have a loan forgiven or discharged. A loan forgiveness program will repay a percentage of a former student's educational debt in exchange for work in a designated job. Unlike service payback programs, which pay for educational expenses while the student attends college, forgiveness programs payoff a loan after the borrower starts working. Once again, there is an entire article dedicated to this topic: Student Loan Forgiveness. That article talks about the various programs that exist, as well as how to qualify.

Repayment Options

The fourth option involves taking advantage of one of several loan repayment programs. Options include both a graduated and income sensitive payment program. These plans allow borrowers to increase their monthly payments over time, or have them automatically adjusted as family income increases or decreases. These arrangements are covered more thoroughly in our article: Student Loan Repayment.

Loan Consolidation

Finally, it might be possible to find relief from high monthly payments by consolidating loans. As soon as a student graduates, or drops below half time enrollment status, they are eligible to consolidate any Direct or FFEL Loans that are outstanding. Anyone that has been delinquent in paying back federal student loans may not be immediately eligible for loan consolidation. If that is the case, then contact the lender to find out what corrective actions can be taken to become eligible once again. More details about this alternative can be found in our article: Student Loan Consolidation.

Federal Student Aid Ombudsman

The Department of Education has established an ombudsman to help anyone thinking about declaring bankruptcy as a result of their student loans. This office has checklists and tools that can help figure out the best approach to deal with a financial crisis. Think of the Ombudsman as a consumer advocate for student loans. For more information about this service, just visit the FSA Ombudsman website.

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