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:

  1. An educational benefit overpayment or loan that was made, insured, or guaranteed by a governmental unit; or
  2. 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
  3. An obligation to repay funds that you received as an educational benefit, scholarship, or stipend; or
  4. 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.

Bankruptcy Courts Have Said These are NOT Student Loans

  • Money owed to your school for past due tuition.
  • A loan given by your school in the form of a tuition credit.
  • A private student loan from a for-profit entity with no nonprofit funding or guaranty to:
    • Attend a school that is not eligible to receive federal student aid funding under Title IV.
    • Pay education expenses for someone who is not a dependent or your spouse at the time the loan was obtained.
    • Pay education expenses for your boyfriend or girlfriend, even if you later marry that person.
  • Credit card debts incurred to pay the costs of education.
  • Home equity lines of credit and mortgage refinance proceeds incurred to pay the costs of education.
  • A personal loan from a friend or family member, even if you use the money for education.
  • Loans given to law school graduates taking the bar exam.

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.