Myth Of The Day: Private Student Loans Are Discharged In Bankruptcy

Average Undergraduate Debt Provided by FinAid.org

I have found in my bankruptcy practice that former students often attribute a large portion of their financial hardship to student loans. Unfortunately, one of the most common public misunderstandings regarding bankruptcy law I see involves the dischargeability of student loans.

Let me just get this off my chest right now: in the vast majority of cases, student loans (regardless of whether they are public or private) cannot be discharged by bankruptcy. Ok, much better. For those of you still reading, let me explain a little further.

For those unaware of the process, student loans are available by both federally and privately managed programs. Typically, government funded loans are determined based upon need, expected familial contribution and a school-estimated cost of program. These loans may be subsidized or unsubsidized based on loan amount and other variables. For those not qualifying or those needing additional monies, privately financed loans have historically been available at higher interest rates and less flexible repayment plans.

In regards to bankruptcy law, it has always been the case that federally backed student loans are generally non-dischargeable in bankruptcy unless undue hardship can be proven. In 99.9% of the cases I see, undue hardship cannot be proven. This makes sense, as they are generally awarded in large amounts to a high risk sector without qualifying credit. Personally, federally granted students loans was the first type of credit extended to me. Without such a caveat, I believe that the program would be quickly crippled.

However, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 extended this designation to private student loans as well. Specifically, Section 523(a)(8) of bankruptcy law states that student loans cannot be discharged, unless payments of the student loans would impose an undue hardship upon the debtor or dependents.

Furthermore, it defines a student loan is defined by the following parameters: (1) it must have been made under a government or nonprofit student loan program, or (2) it must be a qualified educational loan under section 221(d)(1) of the Internal Revenue Code, for attending an eligible education institution as defined in section 221(d)(2) of the Internal Revenue Code, and incurred for costs of attendance as defined in section 472 of the Higher Education Act.

If you read closely, there is some wiggle room for non-traditional cases. For example, perhaps your loan covered education at a trade school or skills program, which is not an eligible institution as described by the Higher Education Act. Or, perhaps the loan was made while attending an eligible institution, but was not incurred for cost of attendance. Maybe, despite using it for tuition, the loan itself was not designated as a student loan.

Thus, as always, I recommend that you speak with a qualified bankruptcy attorney to determine whether your student loans can be discharged in bankruptcy. But as a piece of advice, don’t get your hopes up. If you are in the Phoenix area and would like to set up a free bankruptcy consultation with an affordable and qualified Arizona bankruptcy attorney (that’s me!), feel free to contact me at our Phoenix office.

As one final point, be prepared for these laws to change. The current administration has expressed concern regarding the current state of education debt. Many of you may already know about the Health Care and Education Reconciliation Act of 2010, which aims to cut out the middle man in education lending, cap loan repayments and increase Pell Grants.

What you may not know is that last September Rep. Steve Cohen (D-Tenn.), chair of the House Judiciary Subcommittee on Commercial and Administrative Law, held a hearing to initiate legislation reversing the 2005 changes to made in bankruptcy law that allow private school loans to pass through a bankruptcy discharge. He believes this law gives private lenders a “favorable and unusual” advantage over borrowers, and wants to give “private student loan borrowers more equitable treatment during the bankruptcy process.”

Well, I guess only time will tell. I will be sure to keep you informed of any updates.