Using Bankruptcy to Solve Student Loan Problems
The Ultimate Guide for Student Loan Borrowers and The People Who Love Them
For years, bankruptcy lawyers have been saying you can’t use bankruptcy to protect you from student loans. This has been repeated by the media and student loan servicers for so long that everyone thinks it’s true.
The reality is very different. In fact, bankruptcy can be a useful tool for dealing with your student loans.
Discharge of student loans in bankruptcy is not impossible but, because we’ve been trained to believe that the requirements to do so are too demanding, very few people even try. For the right person, however, the discharge of student loans in bankruptcy case be a powerful tool.
Even if your student loans aren’t going to be wiped out in a bankruptcy case, you may decide file in order to:
Attack the validity of the ownership, enforceability or balances on private student loans
Adjust monthly payments on federal and private student loans
Cure defaults on private student loans
Resolve other debt issues to make it easier to afford student loan payments
A Student Loan Isn’t Always a Student Loan
The U.S. Bankruptcy Code does not except student loans from discharge. Instead, it lists specific types of educational debts that survive the end of the case. If your student loan does not fit the definition of the type of educational debt listed in the bankruptcy law then it will be discharged at the end of the case. For that reason, it’s important to look at the loan and make sure it fits – or doesn’t – before your case is filed.
Your student loan will not be discharged at the end of the case if it was:
- An educational benefit overpayment or loan that was made, insured, or guaranteed by a governmental unit; or
- An educational benefit overpayment or loan that was made under any program funded in whole or in part by a governmental unit or nonprofit institution; or
- An obligation to repay funds that you received as an educational benefit, scholarship, or stipend; or
- Any other educational loan that is considered a qualified education loan under the federal tax laws.
An Educational Benefit Overpayment or Loan: You probably know what constitutes a loan – someone lends money to someone else. An educational benefit overpayment occurs when a student receives a government grant or federal student loan and withdraws from classes after the school’s “add/drop deadline.” Up through the 60% point in each semester, the school uses a schedule to determine the amount of federal funds the student has “earned” as of the time of withdrawal. After the 60% point, a student is considered to have earned 100% of the federal funds he or she was scheduled to receive. Because the federal funds are disbursed at the beginning of the semester or school year, the remainder is considered to be an educational benefit overpayment.
Made, Insured, or Guaranteed by a Governmental Unit: If the loan was issued by the federal or state government then it will not be automatically discharged. In addition, a loan issued or guaranteed by a foreign government will not be automatically discharged under the bankruptcy laws.
Funded by a Governmental Unit or Nonprofit Institution: A loan issued by your school won’t be discharged if the government guaranteed the loan; an example of this would be a Perkins Loan, which is issued by the school using federal funds. Private student loans may also fall under this exception if the bank used a nonprofit entity as a funding or guaranty entity. Loans held or originated under the National Collegiate Student Loan Trust system and many originated by Sallie Mae (now known as Navient) were funded or guaranteed by nonprofit entities for exactly this reason.
Qualified Education Loan: The U.S. Tax Code defines a qualified education loan as a debt you take solely for qualified higher education expenses, for yourself, your spouse, or your dependent. Qualified education expenses are defined as the cost of attendance at a school eligible to receive federal student loan funds under Title IV of the Higher Education Act.
Undue Hardship: The Standard for Discharging a Student Loan in Bankruptcy
In order for a student loan to be discharged, you first need to file a bankruptcy case (most people file under Chapter 7 or Chapter 13). From there, you have to file a separate lawsuit, called an adversary proceeding, in bankruptcy court. You can bring an adversary proceeding to discharge student loan debt at any time while the case is open, and the case may even be reopened after it is closed in order to file your adversary proceeding.
As with any lawsuit, there is a Plaintiff (that’s the person who brings the adversary proceeding) and one or more Defendants (usually the lender, any servicers, guaranty agencies and, in the case of federal student loans, the government). It is the Plaintiff’s responsibility to meet the legal standard of proving undue hardship in court.
The process begins with the Plaintiff filing and serving a Complaint on the Defendants. Each Defendant gets a limited period of time to file an Answer or risks a default judgment against them. From there, both parties move through a pre-trial process called discovery, which allows both sides to trade documents, information, and collect testimony through depositions. At the conclusion of the discovery phase, the court holds a trial and issues a decision.
The goal of the adversary proceeding is to prove to the bankruptcy judge that requiring repayment of your student loans after bankruptcy would cause an undue hardship on you and your dependents. The problem, however, is that undue hardship means doesn’t always mean what we think it means.
Standards for Proving Undue Hardship
In order for a student loan to be discharged, the judge must determine that requiring repayment after bankruptcy would cause an undue hardship on you and your dependents. Because the term undue hardship isn’t defined in the law, different standards have been established over time.
The Brunner Test
The Brunner Test, named after a landmark bankruptcy court case decided back in 1976, set out a three-part test to determine whether undue hardship exists. Though Brunner is widely regarding as an outdated standard, it remains the guiding principle in most of the country.
A finding of undue hardship requires you to prove all of the following:
- You cannot maintain, based on current income and expenses, a “minimal” standard of living for yourself and your dependents if forced to repay the loans;
- Additional circumstances outside of your control exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period of your student loans; and
- You have made good faith efforts to repay the loans.
Explaining the Brunner Elements
As to the first element, the issue is one of a minimal standard of living. The court will look closely at your expenses and, if there is anything that can be cut to pay the student loans then you will lose the argument that you cannot repay the loans and maintain a minimal standard of living.
The second element tries to look into the future. Given the fact that this is impossible, courts require borrowers to present additional circumstances to prove that their present financial situation will persist well into the future, preventing them from making payments through a substantial portion of the loans’ repayment period.
It’s more than your present inability to pay the loans – you’ve got to prove insurmountable barriers to your financial recovery and ability to repay. These additional circumstances include:
- Serious mental or physical disability affecting your employment or advancement;
- Your obligation to care for dependents;
- Lack of, or severely limited education;
- Poor quality of education;
- Lack of usable or marketable job skills;
- Maximized income potential in the chosen educational field and no other more lucrative job skills;
- Limited number of years remaining in your work life to allow payment of the loan;
- Age or other factors that prevent retraining or relocation as a means for payment of the loan;
- Lack of assets, whether or not exempt, which could be used to pay the loan;
- Potentially increasing expenses that outweigh any potential appreciation in the value of your assets and/or likely increases in your income; or
- Lack of better financial options elsewhere.
The third element looks at good faith efforts to repay the loans. Good faith is measured by your efforts to obtain employment, maximize income, and minimize expenses. The courts use several factors in making this determination, including:
- Whether you made any payments before filing for bankruptcy;
- Whether you sought deferments or forbearance;
- The timing of your attempt to have the loan discharged;
- Whether your financial condition resulted from factors beyond your reasonable control; and
- Your efforts to negotiate a repayment plan.
The process can be very expensive and the outcome uncertain, which is why my preference is to look at your entire financial situation and consider bankruptcy only if it would also benefit you if your student loans can’t be forgiven. If an adversary proceeding makes sense at that time, we can review it.
The Totality of the Circumstances Test
Not every court uses the Brunner test. Courts in Arkansas, Missouri, Iowa, Nebraska, Minnesota, North Dakota and South Dakota use the totality of the circumstances test. This test requires the debtor to prove undue hardship based on three factors:
- The debtor’s past, present, and reasonably reliable future financial resources;
- The debtor’s reasonable and necessary living expenses; and
- Any other relevant facts and circumstances.
Some people see this as being more flexible than Brunner, but in some ways it is far more difficult because these courts have adopted what’s called an all-or-nothing approach that prevents the judge from discharging a portion of the student loans. Faced without the option to find a middle ground, courts in these states may end up being less likely to agree with your claim of undue hardship.
Other Ways to Use Bankruptcy for Student Loan Debt
If you think of bankruptcy only as a tool to discharge debt, then you don’t understand the full power of the bankruptcy laws.
Bankruptcy’s primary goal is one of equity – a legally-mandated way of balancing the scales in an inherently unfair system. People who owe money are looking for help, whereas companies that lend money are looking for immediate payment in full. The bankruptcy laws are an attempt to give both sides a little of what they need while not taking advantage of one another.
I’m not saying it’s a perfect system; in fact, there’s a lot wrong with the bankruptcy law as it applies to helping individuals and families. But within that imperfection you can find opportunities for creating a better and more stable financial future – even if it doesn’t result in discharging your student loans.
Challenge the Validity of Student Loans in Bankruptcy
In Chapter 13 bankruptcy, a person files a plan to repay a portion of their debts over a period of 3-5 years. The bankruptcy court appoints a trustee to collect those payments and distribute funds to the creditors once the judge approves the terms of the plan.
In order to receive payment from the trustee, a creditor needs to file a document called a Proof of Claim. That Proof of Claim needs to include certain information related to the debt, and a failure to provide all of the information may lead the judge to deny the right to receive payment.
For student loan borrowers, the Proof of Claim provides insights to the debt that may not otherwise be available. The creditor can be forced to provide a copy of the Promissory Note, payment history and proof of any transfers of the debt from one entity to another. If a student loan lender doesn’t have the proof needed to substantiate the claim for payment, it is within the court’s power to rule that the lender has no right to collect the debt.
In this way, the Proof of Claim allows the student loan borrower to turn the tables on the lender. Rather than waiting to defend a student loan lawsuit in the hopes of obtaining relief or a settlement, the borrower can force the student loan company into bankruptcy court.
Cure a Defaulted Private Student Loan
The bankruptcy law allows a person to cure a default on any loan so long as the final loan payment is due after the end of a Chapter 13 Plan. Though this provision of the law is usually used to catch up on mortgage or vehicle loan arrears, in some situations it may also work for people who have a defaulted student loan.
There are limitations to how and when someone can use this provision, called cure and maintain. In fact, many courts have held that the student loan lender can’t receive a greater percentage of the overall debt than other creditors. For that reason, it may make sense to consider the option of filing a Chapter 7 bankruptcy to discharge other debts before going into Chapter 13 to deal with the defaulted student loan.
Regardless, the ability to cure a defaulted student loan presents an option that you shouldn’t overlook.
Make Student Loan Payments More Affordable
Bankruptcy may provide a way to reduce your other monthly debts so you can afford the student loan payments. Once you complete your bankruptcy case, you may find it easier to make your student loan payments. Those payments will reflect as a positive post-bankruptcy credit history, increasing your credit score in a shorter time than might otherwise be the case.
You may also use bankruptcy as a tool to force student loan lenders to accept lower payments for a period of time. This gives you a chance to stop collection activities, wage garnishments and other enforcement actions while you work on stabilizing your household finances.
Neither of these are perfect solution to your student loan problem because you will remain responsible for the student loan after the case is over, and interest continues to accrue on the unpaid balance. But sometimes it’s better to get some relief rather than continuing to sink under the weight of overwhelming student loan debt.
Take the Time to Map Out the Right Plan
Remember that bankruptcy is a tool – and, as with any tool, it can be useful in specific situations but not others.
It’s important to review your total financial situation with a student loan lawyer that has extensive experience in bankruptcy as well as non-bankruptcy options. Without a complete analysis and an understanding of the impact of each option available to you, you may end up missing the solution that’s the best fit for your needs.
It’s worth your time to be Money Wise on this subject. Your financial future depends on it.
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About Jay S. Fleischman
Jay S. Fleischman is a student loan lawyer with 24 years of experience helping people with debt and credit problems. He has represented thousands of individuals and families in bankruptcy, as well as in federal and state courts. His practice is limited to to student loan issues.
Jay played a central role in developing the Student Loan Law Workshop, where he personally helped to train over 350 lawyers how to help people with student loan problems. He has spoken at events held by the National Association of Consumer Bankruptcy Attorneys, National Association of Consumer Advocates, and bar associations around the country. He is regularly sought out by national news outlets for his insights on student loans and consumer debt issues.
Jay practices law in New York and California, and advises consumers and attorneys nationwide.