Using Bankruptcy to Forgive Student Loan Debt
Sometimes, no matter how much you try, your student loan debt never seems to go away. You work another job, you make timely payments, and you cut back on expenses and luxuries, but you find that more and more of your paycheck goes towards paying off your debt.
Maybe things get so bad that you think of declaring bankruptcy, as a form of last-ditch damage control before your financial future is irreversibly ruined. The idea is not without its merits, but there are a lot of things you need to know about using bankruptcy to forgive student debt.
What Is Bankruptcy? Chapter 7 and Chapter 13
In legal terms, “bankruptcy” is a federal court process for consumers and corporations alike when they can no longer pay their debts. In the United States, there are many chapters of bankruptcy, but only two that will be relevant to you as a private individual: Chapter 7 and Chapter 13.
If you successfully file for Chapter 7 bankruptcy, your creditors will no longer be able to claim any debts they might have against you. This decision, handed down by a federal bankruptcy court, is permanent; but to achieve it, you will have to turn over your entire financial life to a court-appointed trustee. It is the trustee’s job to liquidate any non-exempt property or assets you own to satisfy your creditors, as well as to ensure that you are being straightforward and honest with the court regarding your inability to pay off your loan debt (i.e., that you are not engaged in any illegal activity that might preclude your payment of the debt, or that you have declared every asset in your possession to the court, etc.)
Simply put, Chapter 7 offers you the choice of ditching your debt in return for giving up any assets the court deems non-exempt from liquidation. Not everyone qualifies for Chapter 7 bankruptcy; for example, if a court determines that you have enough assets at your disposal, you may be denied Chapter 7 bankruptcy. If this happens, Chapter 13 bankruptcy becomes an option.
While the keyword in Chapter 7 bankruptcy is “liquidation,” the key word in Chapter 13 bankruptcy is “reorganization.” To file for Chapter 13, you have to propose a payment plan that shows how you will pay off your creditors between the next three to five years. If you are currently earning enough income where some portion of your debt can be paid off, you will be advised to file for Chapter 13 bankruptcy. If your case is approved, the court will temporarily prohibit your creditors from coming after you until a pre-appointed time expires for you to start paying them back again.
While Chapter 7 bankruptcy offers the possibility of wiping the slate clean and starting your life anew, Chapter 13 bankruptcy is intended for people who do not want to liquidate their possessions and assets to satisfy creditors. If you have property you don’t want to be affected by your bankruptcy case, then not only is filing Chapter 13 a better option, you are legally required to go this route.
Like with Chapter 7 bankruptcy, a trustee will be appointed to oversee the terms of the payment, ensure that the plan you propose is workable with the tax returns and pay stubs you provide as part of your case, and ensure that the plan is being adhered to once it is put into effect.
Bankrate warns that both forms of bankruptcy will ruin your financial credibility for years to come: Chapter 7 bankruptcy stays on your credit score for the following 10 years, and Chapter 13 for the following 7 years.
Filing for bankruptcy is effectively signaling your surrender. By filing, you legally and officially acknowledge that you are not, and never will be, in a position to keep your debt under control and your creditors away from whatever assets you have to settle your debt.
While it may be tempting to throw the towel in at the first sign of trouble, the precise moment you make your bankruptcy official can have a pivotal effect on the decision of a bankruptcy court as to whether or not to accept your application, or, in the case of Chapter 13 bankruptcy, how much you will be expected to pay over the reorganization of your loan.One way to know whether the time has seriously come to consider bankruptcy is to calculate whether the cumulative value of all your assets (your savings, funds, stocks, house, car, etc.) is less than the value on your student loan bills and statements. If yes, then it may be time to talk to an attorney who can represent you in bankruptcy court. This step should only be taken:
- After careful deliberation of your current (and future) financial status
- Repeated and long-term attempts by the loan provider, creditor, or collection agency to satisfy the original loan
- Consultation with a financial advisor or a bankruptcy lawyer
- Being fully aware that even if you have a case for bankruptcy, and even if you successfully file for bankruptcy, it will cripple your credit score and financial credibility (showing up on background checks, credit scores, etc.)
Bankruptcy and Student Loan Debt
While there are certain types of debts that are not protected by bankruptcy courts (like alimony), you can seek protection from creditors over your outstanding student loan debt. And you wouldn’t be alone – according to a report entitled “The Growth of Debt Among Young Americans,” about 20 percent of people aged 18 to 24 (at the age when they are either in college or have just graduated) are late on their payments, or have missed a payment, at least once a year.
Furthermore, a 2012 study done by the Harvard Law School in the American Bankruptcy Law Journal showed that nearly 40 percent of debtors who request a bankruptcy discharge (the successful negation of debts, as decided upon by the court) were granted one.
However, getting a bankruptcy court to waive your loans means that you’ve reached the point where you are on your last legs. For this reason, bankruptcy courts administer an unofficial test, known as the Brunner test, to decide whether a case for discharge has merits. There are three components to the Brummer test:
- The student loans prevent you from maintaining a minimal standard of living.
- You have repeatedly taken measures to increase your income or eliminate undue expenses, without enough success.
- Your financial hardship is likely to continue for a considerable duration of the life of the loan.
If a court is satisfied that your case meets the three factors of the Brunner test, they may find in your favor and issue a discharge. However, Bloomberg Businessweek writes that this is “far from easy,” and “almost impossible to meet.” Not only do you have to prove that you are effectively penniless, but you have to convince a court that your situation will not improve for as long as the loan exists – and that could be a period of close to 10 years. The New York Times calls that feeling “the certainty of hopelessness.” Even if it persuades a court to forgive your student loan debt, it is not a good place to be. A teacher of bankruptcy law at Boston University’s School of Law told US News & World Report that “bankruptcy is a major disruption in your life,” and that it may be preferable to hammer out a deal with your creditors rather than go to court.
If, however, this is where you find yourself, you should know that it’s up to you to get the ball rolling. This is important, because the 2012 Harvard Law School study showed that literally 99.9 percent of student debtors did not ask their bankruptcy judge to write off their student loans. The study’s writer put it down to “a lack of accurate knowledge” of how the bankruptcy system works.
Alternatives to Bankruptcy
Bankruptcy is an extreme step. Even though 1.4 million people filed for bankruptcy in 2009 (from the AAA Fair Credit Foundation), it should not be thought of as a “get out of jail free” card to shrug off your student loan debt, but as a last resort when your best efforts have proven futile, and you can honestly show that the next five or so years of your life will be critically affected because of this burden. And even if you get that bankruptcy discharge, the mark it leaves on your credit score and personal background is as undesirable as the debt that set this whole thing in motion.
Fortunately, even if you are down to the skin of your teeth, you have other options you can explore besides bankruptcy. One of them is debt consolidation, where all your outstanding debts – college, credit card, car payments, etc. – are combined (or consolidated) into one single loan that, in theory, is easier to manage.
While having one big loan sounds better than having four little loans, there are dangers to debt consolidation. Combining your debts will prolong the term of the loan. Even though you’re only paying off one loan, you’ll be doing that for a much longer period of time than when you had multiple loans.
Some financial analysts, like Dave Ramsey, also caution that debt consolidation doesn’t safeguard you from making the same mistakes that many people did that landed them in trouble to begin with. In other words, consolidating all your loans into one doesn’t mean that other harmful spending habits (living beyond your means, continuing to use a credit card, etc.) are suddenly removed from the equation. Also, the debt consolidation services that do the legwork on merging your debts into one will charge their own fees, thereby adding to your pile of expenses.
Another alternative to using bankruptcy to forgive your student loan debt is known as debt forbearance. This allows you to delay your payments, or reduce the amount you have to pay. Both offer only temporary respite from your creditors, however, and you can only qualify for debt forbearance under certain stipulations.
Other options might involve speaking to financial counselors who might help you renegotiate the terms of your student loan with your creditors in order to do some damage control before taking the extreme step of going to bankruptcy court.
Should You File for Bankruptcy to Take Care of Your Student Loan Debt?
If you find yourself contemplating filing for bankruptcy because your student loan debt seems like it has taken control of your life, examine all your choices before making that step. Bankruptcy can save you from a lifetime of financial misery and destitution, but it is a life-changing commitment that should not be approached hastily or lightly. Take some time to browse the articles and the resources on our site to learn more about your options.
Types of Student Loans
- Student Loans Home
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- GI Bill
- Interest Free
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- No Cosigner
- No Credit Check
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- Parent Plus
- Part Time Students
- Post 911 GI Bill
- Private Loans with No Cosigner
- Private School
- Subsidized Loans
- Without Cosigner