Here’s What Really Happens to Student Loans When You File Bankruptcy

Here’s What Really Happens to Student Loans When You File Bankruptcy

Note that the situation for student loans has changed due to the impact of the coronavirus outbreak and relief efforts from the government, student loan lenders and others. Check out our Student Loan Hero Coronavirus Information Center for additional news and details.

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Can student loans be included in bankruptcy? Possibly.

Bankruptcy does not automatically discharge student loans, but there are instances where you could get your student loan debt wiped clean.

The simplest way to understand what happens to student loans in Chapter 7 and 13 bankruptcy is to examine these two types of proceedings, as well as some alternative routes:

What happens to student loans in Chapter 7 bankruptcy?

Chapter 7 bankruptcy usually results in a liquidation of your assets. To file for Chapter 7, your current monthly income must be below the state median. If it’s not, you need to pass a means test to determine whether you have disposable income to pay the debt under a Chapter 13 plan. Unlike Chapter 13, Chapter 7 has no repayment plan. Some debts are fully discharged, while others are not.

Chapter 7 in the news
A January 2020 bankruptcy court decision discharged the $221,385.49 student loan debt of a U.S. Navy veteran, stemming from his Chapter 7 proceeding. However, the possible watershed ruling was ultimately appealed by the borrower’s loan servicer.

Here’s what happens to student loans when you file Chapter 7:

Lenders stop hounding you for money. Upon filing your Chapter 7 bankruptcy petition, an automatic stay is granted like it is with a Chapter 13 filing.

There’s no automatic student loan debt discharge. Under Chapter 7 bankruptcy, your student loans are not automatically discharged. To have your student loans considered for discharge, you can file a complaint to determine dischargeability, which initiates what’s known as an adversary proceeding.

You (and an attorney) attempt to prove your case for financial hardship. It may not be as hard to discharge student loans as you have been led to believe. In the case of extreme financial hardship that results in having very little to contribute toward the repayment of your debts overall, the court may decide to discharge your student loans completely.

The process is quite difficult and rarely happens, but it is possible. According to a study published in 2011 that is still cited often, 40% of those who initiated the adversary proceeding were able to discharge all or part of their student loans.

However, only 0.1% of those who file Chapter 7 petitions filed the complaint to determine dischargeability — in other words, people are so convinced it’s a near-impossibility that they don’t even try.

The student loan holder may oppose your undue hardship claim. A July 2015 letter from the U.S. Department of Education advises loan holders on how this determination is made: “First, a holder must evaluate a borrower’s undue hardship claim and determine whether the holder believes that repayment would constitute an undue hardship according to the legal standards set by the federal courts.”

If the loan holder believes you’ve proven undue hardship, it may not oppose. However, if the loan holder doesn’t believe you’ve proven undue hardship, it may oppose, but not before running the numbers on just how much such an opposition will cost.

The court may use one of two tests to determine undue hardship. There’s the Brunner test and the Totality of the Circumstances test. The criteria for each test is outlined in the Education Department letter referenced above.

Under the Brunner test, you must show that:

  • Paying back your student loans will make it impossible for you to maintain a minimal standard of living
  • Your financial situation is not likely to change anytime soon
  • You’ve made good-faith effort to pay back your student loans

Under the Totality of the Circumstances test, the court considers:

  • Your past, present and likely future financial resources
  • Reasonably necessary living expenses
  • Other relevant facts and circumstances

While these are the two most common tests, some courts use others. A bankruptcy attorney should be able to tell you which test is used in your jurisdiction.

Ultimately, it boils down to proving you’re experiencing undue hardship. Undue hardship is living under circumstances that make it next to impossible to fulfill your financial duties. Maybe you’re living below the poverty line, you have a disability that makes you unable to work or you qualify for food stamps. These quality-of-living factors could help you prove you’re unable to repay your student loan debt.

The court makes a decision. If the court finds that you have, indeed, proven undue hardship, you may have all or part of your student loans discharged. If the court finds that you have not proven undue hardship, your student loans will not be discharged and you’ll be responsible for paying them back in full.

Student loan account closed after Chapter 7?
● If your student loans are discharged completely via bankruptcy, you can expect your student loan account to close (though record of the bankruptcy itself may remain on your credit report for 10 years). Still, it’s wise to seek confirmation from your bankruptcy attorney.
● Keep in mind that if your loans are only partially discharged, your student loan account with your lender(s) will remain open, reflecting whatever balance you may still owe. To avoid delinquency and default on that remaining balance, consider the debt repayment strategies detailed in the table below.

What happens to student loans in Chapter 13 bankruptcy?

Chapter 13 bankruptcy is a reorganization where you’re required to repay part of your debt, likely over three to five years. Some of your remaining debts may be discharged at the end, including student loans.

Chapter 13 in the news
In August 2020, a bankruptcy court affirmed the cancellation of $200,000 in education debt for a Colorado couple. The potentially landmark ruling was the final result of a Chapter 13 filing.

Here’s what happens to student loans under Chapter 13 bankruptcy:

Lenders stop hounding you. Upon filing your Chapter 13 bankruptcy petition, an automatic stay is granted. This prohibits most creditors — including student loan servicers — from trying to collect debts. This protection typically continues through your repayment period.

Student loans don’t take top priority. Student loans in Chapter 13 bankruptcy are considered nonpriority unsecured debt. This means you aren’t required to pay the full amount of your student loans through the Chapter 13 repayment plan.

Your monthly payment may change. The amount you end up paying toward your student loans in Chapter 13 bankruptcy depends on your repayment plan. Your student loans receive a pro rata share, which will likely represent a dollar amount less than your regular monthly student loan payment. In some cases, your student loan debt might be discharged (more on this below).

Making full monthly payments may not be possible. If you want to continue paying your student loans in full outside Chapter 13 bankruptcy, you need to check. Some jurisdictions deny this because the full payments reduce what certain unsecured creditors would be paid during bankruptcy.

Student loan interest can mount. Your student loans may continue to accrue interest over the three- to five-year term of your Chapter 13 repayment plan, since you’re most likely not making full payments.

Student loans can come back to haunt you. Once the repayment plan is over, you may be responsible for the remainder of your student loans because they may fall into the non-dischargeable debts category. This category can also include child support, unpaid taxes, debts for damages caused by you or debt from restitution orders. As you can see, not all debt disappears after a bankruptcy, so you should get advice from a professional before you file.

What are alternatives to bankruptcy for student loans?

About 250,000 student loan borrowers file for bankruptcy annually, according to academic research from Villanova University — but perhaps you shouldn’t be among them.

Before filing for bankruptcy, find out if you’re eligible for these alternatives for your student loans:

Income-driven repayment (IDR) IDR plans may be available for those with federal student loans. These plans base your monthly payment on your discretionary income, so if you’re experiencing a period of unemployment or underemployment, your payments can be adjusted to make them manageable. After 20 to 25 years of making payments under an IDR plan, your loans may be forgiven.
Deferment or forbearance Both deferment and forbearance put a pause on your federal student loan payments if you decide to go back to school or you’re having trouble making ends meet. While in deferment, you may not have to pay for the interest that accrues (depending on the type of loan), though while in forbearance, you’re required to pay interest on the loan. Private student loan companies may offer deferment or forbearance options as well.
Debt consolidation A debt consolidation or management plan would allow you to group your loans, ideally at a lower interest rate or monthly payment. Consolidation could be out of reach if you have poor credit or no access to a cosigner. In that case, a debt management plan set up through a nonprofit credit counseling agency could put you on track to zero your balances within three to five years.
Discharge In certain situations, your federal loans may be completely discharged. A total and permanent disability or the closing of your school could qualify you for a federal student loan discharge.

Rather than filing for bankruptcy, getting an income-driven repayment plan or requesting a temporary stop to payments could help you get back on your feet.

What do you need to consider before you file bankruptcy?

Now that you know what happens to student loans in Chapter 7 and 13, you might be ready to move forward. But remember: Bankruptcy should be treated as a last resort under any circumstance.

If you’ve asked “can student loans be included in bankruptcy,” make sure you’ve exhausted every other possibility before pursuing this. By that point, you have already compared debt consolidation versus bankruptcy, for example.

The information we’ve provided on bankruptcy and student loans is not intended to replace legal advice. For recommendations specific to you, consult with a bankruptcy attorney. Finding a student loan lawyer might be easier than you’d think.

Andrew Pentis and Taylor Gordon contributed to this report.

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