When you’re struggling to pay back your student loans, what’s your next step? With Americans owing approximately $1.7 trillion in student debt, you’re not the only one asking this question. With bills piling up, some might even consider bankruptcy.
The question is, does bankruptcy clear student loans?
Well, it is possible to discharge student loans in bankruptcy but it is difficult and rare. Read on for information on types of bankruptcy and other requirements there may be in order to potentially qualify to have student loans discharged in bankruptcy.
Can You File Bankruptcy on Student Loans?
It’s very unlikely. Discharging your student loans through bankruptcy requires proving to the court that you would suffer from “undue hardship” if forced to repay.
While this may sound like you—honestly, who doesn’t see that monthly payment as an undue hardship?—it’s worth thinking twice before contacting your nearest bankruptcy lawyer. If it were easy to use bankruptcy to clear student loan debt, there probably wouldn’t be millions of Americans still making payments, so this isn’t something anyone should count on.
What Does It Mean to Declare Bankruptcy?
Bankruptcy is a way of clearing your debts—which adversely affects your credit—through the court system, whose job is to sort through your assets and determine what debts to forgive that you’re unable to pay.
Chapter 7 Bankruptcy
Chapter 7 bankruptcy is also sometimes referred to as liquidation bankruptcy. In this case, assets of the person filing for bankruptcy will be liquidated—or sold—by the bankruptcy trustee. There are some exceptions of “exempt” property, but everything else will be liquidated in the bankruptcy. Generally, people who consider Chapter 7 are those with minimal assets or a lower-income.
What is defined as an exempt property can vary from state to state. In general, it may be possible to preserve some home equity, furniture, clothing, and some other necessities.
Chapter 7 bankruptcy is generally filed as a last resort.
Chapter 13 Bankruptcy
Chapter 13 bankruptcy can be referred to as a “wage earner’s plan .” In this case, people filing bankruptcy can create a repayment plan to pay off their debts. Depending on the person filing’s financial situation, repayment may take place over either three or five years. Chapter 13 bankruptcy is more suited for individuals with valuable assets or who are earning considerable income.
In order to file Chapter 13 bankruptcy, certain debt limits must be met. As of this writing, unsecured debts, those not backed by collateral, must be less than $394,725. Any secured debts must be worth less than $1,184,200.
Filing Bankruptcy on Student Loans
So if nearly 20% of Americans with student loans are in default, why haven’t they declared bankruptcy? Simple: It’s extremely difficult to qualify to discharge student loans through bankruptcy. After all, if that kind of legal loophole existed for student loan debt, there would be nothing to stop people from graduating college and then immediately declaring bankruptcy.
While bankruptcy could provide some relief to individuals who are overwhelmed by immense debts, doing so has serious consequences. Bankruptcy is generally a last resort and filing for bankruptcy can have lasting impacts on an individual’s credit score.
Individuals struggling to stay on top of their debts should carefully weigh all of their options before filing for bankruptcy. Some alternatives to consider may be consulting with a credit counseling agency or contacting your creditors to negotiate a repayment plan. It can also be helpful to meet with an attorney who can provide more detailed information and personalized advice.
To have a shot at student loans being discharged in bankruptcy, the person filing typically needs to file additional action with the court, known as an “adversary proceeding ,” which is essentially a request that the court find that repaying the student loans would in fact be an undue hardship to both the individual and their dependents, if they have any.
Most, but not all, courts use the ‘Brunner Test’ to determine whether or not a borrower may qualify to discharge student loans in bankruptcy.
The qualifications for the Brunner Test include:
1. The borrower and their dependents cannot maintain a minimal standard of living if forced to keep paying their student loans. This is based on your income and expenses.
2. Additional circumstances exist indicating that your challenges are likely to persist for a significant portion of the student loan repayment period.
3. A good-faith effort has been made to try and repay the loans.
That criteria sets a high bar to qualify for discharging student loans in bankruptcy and in most cases, it takes extraordinary circumstances to do so.
What Happens If the Court Finds There Is Undue Hardship?
In the unlikely event that the court finds that repaying the student loans would indeed put an undue hardship on the person filing for bankruptcy, there are a few different things that could happen .
• The loans might be fully discharged. This means that the borrower will not need to make any more loan payments. All activity from collections agencies would stop too.
• The loans may be partially discharged. In this case, a portion of the debt would be discharged. The borrower would still be required to repay the portion of the debt that is not discharged.
• The loan terms may change. In this situation, the borrower will still be required to repay the debt. But there will be new terms on the loan, such as a lower interest rate.
What Alternatives Could Help Me Pay Off My Student Loan Debt Without Declaring Bankruptcy?
Fortunately, there are alternative options to declaring bankruptcy.
For short-term solutions for federal student loans, deferring the loans or going into forbearance, could be options to consider if you qualify. These options allow borrowers to temporarily pause their student loan payments.
Unlike declaring bankruptcy, federal student loans in deferment or forbearance generally don’t negatively affect your credit.
Another option for federal student loans is switching to an income-driven repayment plan, which ties your monthly payments to your discretionary income. If your income is low enough to meet the thresholds for these plans, this could bring payments down significantly, though interest will still continue to accrue.
Private student loan lenders may offer temporary assistance programs that could help borrowers who are struggling to make payments on a temporary basis.
It may also be worth negotiating: One option could be to contact the loan servicer or lender and ask for additional repayment options. In general, servicers or lenders would rather receive a smaller sum of money from you than nothing, so it’s typically in their best interest to work with you.
Is Refinancing an Option?
Deferring loans and forbearance are ultimately short-term solutions. If you’re looking for a long-term solution to reduce student loan debt, refinancing could be worth looking into.
Refinancing your student loans means transferring the debt to another lender, with new terms and new (ideally, lower) interest rates.
Some borrowers may be able to qualify for lower interest than the federal rates depending on your financial standing. But, keep in mind that when federal student loans are refinanced, they lose all eligibility for federal student loan borrower protections—like the deferment, forbearance, and income-driven repayment plans mentioned above.
If you’re looking to refinance, make sure you do your research and see if you can find competitive rates with a lender you trust.
While it may be possible to discharge your student loans through filing for either Chapter 7 or Chapter 13 bankruptcy, doing so can be extremely challenging—and succeeding is very unlikely. In addition to filing for bankruptcy, borrowers generally need to prove that continuing to repay the loan would place an undue burden on them and their dependents. And don’t forget: bankruptcy has considerable downsides, including the possible loss of assets and a substantial hit to your credit score that can last for years.
For federal student loan borrowers who are struggling with their student loan payments, deferment or forbearance may provide temporary solutions.
Federal student loan borrowers may also consider switching to an income-driven repayment plan, which ties their debt payments proportionally to their discretionary income. In some other cases, it might make sense to consider refinancing.
Bankruptcy Information: This article provides general background information only and is not intended to serve as legal/tax or bankruptcy advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal/tax or bankruptcy advice.
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