Can Student Loan Borrowers Use Bankruptcy to Get Rid of Debt?

Student loan borrowers can file for bankruptcy, but it should only be considered as a last resort, multiple student loan experts told Newsweek after the Supreme Court struck down the Biden administration's student loan forgiveness program on Friday.

President Joe Biden's plan would have affected some 43 million Americans by canceling up to $25,000 worth of debt for Pell Grant recipients and up to $10,000 for borrowers with an income lower than $125,000. Approximately 20 million of those 43 million borrowers would have had all their higher education-related debt completely wiped out.

Federal guidelines for bankruptcy filings

According to studentaid.gov, run by the Department of Education (DOE), borrowers may have their federal student loans discharged in bankruptcy only if they file a separate action of "adversary proceeding"—essentially a request of the bankruptcy court citing repayment imposing "undue hardship" on the borrower and his or her dependents.

That scenario would require proof by the borrower of that undue hardship, with claims that can be challenged by present creditors who are attempting to collect the loan payments. While no single litmus test is used in such proceedings, a bankruptcy court is requested to look at multiple aspects of the borrower's life.

The DOE has adhered to guidance presented by the Department of Justice (DOJ), as part of a 16-page memorandum released last November that it says "will help ensure consistent treatment of the discharge of federal student loans, reduce the burden on borrowers of pursuing such proceedings and make it easier to identify cases where discharge is appropriate."

It includes three main provisions:

• Whether the borrower in question is not able to maintain a minimal standard of living while paying back said loans.
• If there is evidence that such hardship would continue for a significant portion of the loan repayment period.
• Whether "good faith efforts" were made to initially repay the loan before seeking the option of bankruptcy.

Bankruptcy should be 'Plan Z'

Jacob Channel, senior economist for online loan marketplace LendingTree and a student loan expert, told Newsweek via phone on Friday that getting rid of student loans via bankruptcy is "extraordinarily difficult" and somewhat analogous to telling someone to plan their retirement in the highly unlikely chance that they someday win the lottery.

Approximately 92 percent of student loans are federally backed, Channel said, providing the federal government with a lot more leeway in getting that money compared to, say, credit card companies in the private sector.

Demonstrating "undue hardship" in a bankruptcy court is "damn near impossible without kind of killing yourself in the process," he added.

"Bankruptcy should not be the first choice," Channel said. "It should be Plan Z."

Christian O'Connor, compliance and underwriting manager at lender Yrefy, told Newsweek via phone on Friday that bankruptcy filings by student loans are not just extremely rare, but they're most often associated with private student loan servicers like Navient.

"Their default definition is a lot less stringent than the government," O'Connor said. "For the government you go 365 days before you're placed into default. With Navient or a private student loan, if you miss your first payment you can technically be considered in default—and they can start that process right away."

Jonathan Petts, CEO of the nonprofit organization Upsolve that helps individuals file bankruptcy without using a private attorney, said the total amount of borrowers already in default is more than $124 billion—accounting for about one-fifth of all borrowers, according to Yahoo! Finance.

Nathan Daun-Barnett, associate professor of higher education administration at the University of Buffalo, told Newsweek via email on Friday that the historical roots of bankruptcy filings in student loan cases predate federal direct lending and made it easier to get banks to issue loans, and the fees associated with them.

He added that it remains unclear whether the guidance set forth by the DOJ will lead to a clarification of the overall process.

Income-driven repayment plans reign supreme

O'Connor said that borrowers should immediately determine where their loans are being held and to have all their information up to date with their particular service agency to meet specific payment timeframes and deadlines as systems will soon become "bombarded" by copious amounts of borrowers.

After determining how much is owed, borrowers should look at options that best comport to their own unique situations.

"If everybody starts off in a standard repayment plan, that means you're going to pay off your loan in 10 years," O'Connor said. "You may not be able to afford that payment and we don't want anyone to then find out in October, 'Oh, it's $400 too much. What can I do?' There's gonna be a backlog of people trying to do that."

O'Connor and Daun-Barnett praise income-driven repayment plans as the best option for borrowers, due to being able to pay what you can afford based upon a percentage of your discretionary income—with the loans being discharged after "X" number of years.

"So far, the timelines have been longer than I would like to see," Daun-Barnett said. "I prefer something closer to the Public Service Loan Forgiveness timeline of 10 years of continuous repayment. After that period, the balance would be discharged."

He concluded: "That was part of the Biden plan when they announced the loan forgiveness program. I suspect it will still be a priority for the administration and it was not what was being challenged at the Supreme Court. If we do income-contingent loan repayment well, then I would be less concerned about bankruptcy."