Can you declare bankruptcy on student loans?

Key points

• It’s very difficult to get student loans discharged in bankruptcy.
• To qualify for a Chapter 7 bankruptcy discharge, you must demonstrate undue hardship, which requires proof.
• Private student loans for things like laptops and professional certifications are not qualified education loans, and can be discharged without demonstrating undue hardship.
• Alternatives to bankruptcy discharge may include deferments, forbearances, repayment plans, loan forgiveness and disability discharges.

If only the forgiveness fairy could wave her magic wand to cancel your student loans after you proclaim, “I declare bankruptcy.” It is much more difficult to get your student loans discharged in bankruptcy.

Among other requirements, you have to demonstrate undue hardship, which is difficult to do because there is a very harsh standard.

It’s just not easy to get rid of student loans.

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Filing for a bankruptcy discharge

The two most common types of bankruptcy filings for student loans are under Chapter 7 and Chapter 13. Bankruptcy attorneys are less likely to pursue a discharge of student loans because it is more complicated and more expensive. Keep in mind that you must undergo credit counseling before filing for bankruptcy, and court costs and attorney fees can cost thousands of dollars.

Here’s a look at Chapter 7 and Chapter 13 bankruptcy filings:

Chapter 7

This involves liquidation of your assets, other than certain exempt assets, such as your primary home and vehicle. The proceeds are used to repay creditors, then the remaining debts are discharged. You get a fresh start.

To file for Chapter 7, you must have low income (e.g., below the state’s median income level). You can obtain a chapter 7 bankruptcy discharge only once every eight years. Debts for taxes, alimony and child support cannot be discharged. To get student loans discharged requires a demonstration of undue hardship (more on this later).

Chapter 13

This involves setting up a payment plan, called a reorganization, in which your disposable income is used to repay your creditors over a three- to five-year period.

A key benefit is you can use Chapter 13 to get a lower payment on your private student loans. However, the student loans will continue to exist after the completion of the payment plan, and the loan balance may be higher afterward.

Tip: The bankruptcy discharge will remain on your credit history for 10 years after a Chapter 7 discharge and for seven years for a Chapter 13 bankruptcy.

The undue hardship requirement

The U.S. Bankruptcy Code provides an exception to bankruptcy discharge of most student loans, unless the loans “impose an undue hardship on the debtor and the debtor’s dependents.”

This is a very harsh standard that, in the words of Judge Burton R. Lifland during a bankruptcy court case in 1981, requires “a certainty of hopelessness.” It is much harder to discharge student loans than credit card debt, auto loans and mortgages.

What is undue hardship?

The bankruptcy courts use one of two definitions of undue hardship in the absence of a definition by Congress, depending on where you live. These are referred to as “tests”:

The totality of circumstances test

The requirements under this definition apply to those who live within the 1st and 8th circuits. Your current and future income will be compared with the minimal and necessary living expenses for you and your dependents. Other circumstances that affect your ability to repay the debt are also considered.

The Brunner test

These requirements apply to those who live in the 1st, 2nd, 3rd, 4th, 5th, 6th, 7th, 9th, 10th and 11th circuits. Like the Totality of Circumstances Test, your current and future income will be compared with the minimal and necessary living expenses for you and your dependents. But the Brunner Test adds a requirement that you have to have made a good faith effort to repay the student loans, such as increasing income, cutting expenses and using other repayment options offered by the lender.

An undue hardship petition must be brought in an adversarial proceeding to determine whether the student loans are dischargeable. During an adversarial proceeding the borrower must demonstrate that their situation satisfies the requirements for discharge, subject to challenge by the lender.

When the borrower is required to demonstrate undue hardship, this is most likely to occur when:

• The borrower is disabled and the student loan does not offer disability discharge.
• The borrower’s dependent is disabled.
• The borrower has very low income and no prospects for increasing income.
• The borrower’s income has been reduced by alimony and child support obligations.
• The debt exceeds the borrower’s ability to repay, and the student loan does not offer an income-driven repayment plan.

It is very difficult to demonstrate undue hardship. Not only must your income be so low that you have no discretion in how you spend your money for basic living expenses, even going without some necessities, but you must have no reasonable prospects for increasing income and cutting expenses. If you’re able-bodied, you might not be able to satisfy the requirements.

When are student loans most likely to be discharged?

There are several circumstances that bypass the requirement to demonstrate undue hardship.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 expanded the exception to discharge to include qualified education loans. Qualified education loans include all federal and most private student loans.

But there are certain types of private student loans that are not qualified education loans and therefore are dischargeable without a showing of undue hardship. So, if your bankruptcy is approved, you are automatically released from them.

These include several types of loans, such as:

• Mixed-use loans that were not borrowed solely to pay for qualified higher education expenses.
• Direct-to-consumer loans.
• Bar study loans (covering the costs of the bar exam and studying for it).
• Residency and relocation loans (for medical students).
• Continuing education loans.
• K-12 loans.
• Loans owed to a relative (e.g., brother, sister, spouse, ancestor or descendant).
• Retirement plan loans (to pay for college).
• Loans borrowed for prior-year balances.
• Loans for professional licensing/certification.
• Loans for the purchase of a computer.
• Loans made to students who were enrolled less than half-time.
• Loans made to students who were still enrolled in secondary school.
• Loans for use at a college that is not eligible for Title IV federal student aid.

Alternatives to filing for student loan bankruptcy

Before seeking student loan bankruptcy discharge, you should explore other options for financial relief. These alternatives may be enough to address your economic hardship. Moreover, trying these solutions may be necessary to satisfy the good faith effort required by the Brunner Test.

Deferments and forbearances

These provide temporary suspensions of the obligation to repay student loan debt for borrowers who are experiencing short-term financial distress. Economic hardship deferment, unemployment deferment and general forbearances are available for up to three years each for federal student loans. Forbearances are also available for private student loans, but are usually limited to a maximum of one year in total duration.

Deferments and forbearances are not permanent solutions, since interest may continue to accrue. Any unpaid interest will be capitalized by adding it to the loan balance, digging the borrower into a deeper hole.

Repayment plans

For long-term financial distress, there are repayment plans that may reduce the monthly loan payment. These include extended repayment and income-driven repayment plans.

Extended repayment can cut the monthly payment by as much as half, depending on the repayment term.

Income-driven repayment bases the loan payment on your discretionary income, as opposed to the amount you owe. Income-driven repayment can yield a zero monthly loan payment if your income is less than 150% of the poverty line.

Loan forgiveness and discharge

Student loan forgiveness is available if you work in specific occupations in a national need area for a period of time.

If you’re on an income-driven repayment plan, your debt can be forgiven after 240 or 300 payments (20 or 25 years).

Student loans can also be discharged after the borrower’s death or total and permanent disability.

Refinancing

This might yield a lower payment if you can qualify for a lower interest rate or longer repayment term. However, the amount of relief may be more limited than many people expect.

Cutting the interest rate in half does not cut the payment in half. On a 10-year repayment term, it cuts the loan payment by only about 10% to 20%, because the principal balance does not get cut. Even on a 20-year term, the loan payment decreases by only about a fifth to a third.

A lower fixed interest rate often requires a shorter repayment term, which increases the monthly loan payment. For example, cutting the interest rate from 5% to 2.5% while cutting the repayment term from 10 years to five years will increase the monthly loan payment by two-thirds.

It does reduce the total payments over the life of the loan by 16%, but a significant part of the savings is due to the shorter repayment term, not just the lower interest rate.