In its recent October 1, 2015 report proposing changes to the student loan system, the Department of Education recommended that lawmakers make one type of private student loan debt — loans that don’t offer the option of income-driven repayment — dischargeable in bankruptcy court.
The Obama administration doesn’t want to see a flood of bankruptcy filings if the law is changed. The goal is to prod private lenders into giving borrowers the option to make more manageable payments.
Income-driven repayment plans — which base monthly payments on a percentage of income and can stretch loan terms out as long as 25 years — are the government’s great hope for plugging leaks in its own $1.2 trillion student loan portfolio.
More than 41 million Americans now owe the government student loan debt — nearly $30,000 each on average. The Consumer Financial Protection Bureau estimates that more than one in four of those borrowers are either behind on their loan payments or in default.
Student loan service’s — companies that collect payments on behalf of the government — are now signing up more than 5,000 borrowers a day for income-driven repayment plans, and 16 percent of federal direct student loan borrowers have already been placed in one.
Filing for bankruptcy has allowed millions of Americans to walk away from credit card debt, car loans, and even unpaid medical bills. But there there are two kinds of debt that are difficult to discharge in bankruptcy court: mortgages and student loans.
Congress has made it difficult to discharge mortgage and student loan debt in bankruptcy in part because of the widely shared belief that there are societal benefits to promoting home ownership and access to higher education. Home ownership helps Americans build wealth, and educated workers command higher salaries and are better able to compete in the global economy.
Tough restrictions on bankruptcy discharge are one of the factors that keeps investment capital flowing into home loans and student loans, which helps keep them available and affordable for many people.
When millions of Americans found themselves in foreclosure during the height of the mortgage crisis, lawmakers dismissed calls from consumer advocates that bankruptcy judges be allowed to “cram down” mortgage debt.
The lending industry successfully argued that changing the rules after the fact would spook investors in mortgage-backed securities, which is the source of funding for the vast majority of home loans.
Role of private lenders
While the government now funds about 90 percent of student loans directly, private lenders also make loans to borrowers with good credit, often at lower rates than government loans.
As a result, many graduates with strong prospects are refinancing pricey government loans with private lenders. Many of these loans are of such high quality that they can be bundled up and sold to investors, much like mortgages.
The belief that student loans are never dischargeable in bankruptcy makes us us cringe every time we see it – and we see it a lot.
We cringe because it’s not true. You actually can get your student loan discharged in bankruptcy in some limited cases. In fact, according to a study published in 2011 by Jason Iuliano, at least 40 percent of borrowers who do include their student loans in their bankruptcy filing end up with some or all of their student debt discharged.
The problem is the old tale that has consumers thinking there’s no chance to have these loans discharged, so they don’t try. Iuliano’s report found that only about 0.1 percent of consumers with student loans attempt to include them in their bankruptcy proceedings.
To be clear, if you borrow money, you have a moral and legal obligation to pay that money back, even if that means making some financial sacrifices. It is strongly recommended that students do more cost-benefit analysis and long-range planning before taking on student debt of any amount.