Student loans and bankruptcy are a complicated area, and not many bankruptcy filers understand how bankruptcy affects their student loan debt and what their options are and how they differ between Chapter 7 and Chapter 13 bankruptcy.
Most Student Loans Are Not Dischargeable in Bankruptcy
In general, student loans are not dischargeable in bankruptcy. That means you will still owe them when your bankruptcy is over. (They used to be dischargeable after seven years of repayment, but Congress changed all that in 1998.)
Now, they only way to get rid of your student loans in bankruptcy is to claim that repayment of the loans creates an “undue hardship”. The only way this can be proven is through what is called an adversary proceeding. This is like a separate lawsuit within your bankruptcy case. It involves litigation, and will require expert witnesses, depositions ad other witness testimony. As a result, it is not cheap.
Aside from costing you a good chunk of money, winning an undue hardship discharge is incredibly difficult. Most courts, including Colorado, follow the test set out in the Brunner case out of New York (831 F.2d 395). Brunner is a three-part test in you must prove:
1. That the debtor cannot both repay the student loan and maintain a minimal standard of living;
2. That this situation is likely to persist for a significant portion of the repayment period of the student loans; and
3. That the debtor has made good faith efforts to repay the loans.
This test is applied very strictly, with minimal standard of living judged as living at the poverty level with no discretionary expenses at all. Additionally, discharges are not usually granted absent permanent disability of the debtor (or possibly one of the debtor’s dependents). More information is available at FinAid.
The bottom line is that in the vast majority of bankruptcy cases, discharge of student loans is simply not an option.
Student Loans in Chapter 7 Bankruptcy
When you file for bankruptcy, you are instantly protected by the automatic stay, which prevents creditors from attempting to collect on the debts you owe them. This protection applies to student loan lenders, and as a result, your loans will be put into automatic forbearance once your case is filed.
Interest continues to accrue during the time your bankruptcy case is open, and you will be responsible for those amounts. However, you can take a break from paying your regular loan payments while your Chapter 7 bankruptcy is pending. In fact, this is the easiest way to handle student loans in bankruptcy. Often, your loans are sold once you enter bankruptcy or are transferred to a different department and if you try to make your regular payment they may not be properly credited.
Therefore, if you plan to continue to make payments, it is important to communicate with your lender once you file your case, and to keep records of any payments you make while your bankruptcy case is open.
Student Loans in Chapter 13 Bankruptcy
In a Chapter 13 bankruptcy, which requires steady income and involves a monthly payment for the three-to-five-year life of the plan, student loans can be dealt with in two different ways. First, your student loans can be placed “in the plan” and a portion of your monthly payment will go toward the loan balance(s). However, this monthly amount is likely to be smaller than your regular payments and this approach will not stop interest from accruing on the loans. The automatic stay applies for the life of your Chapter 13 plan and the student loan lenders must accept the smaller payment amount while you are in Chapter 13 bankruptcy (3-5 years). While these payments will be credited to what you owe (interest and possibly even principal), the lender can hold you to the terms of your loan agreement in collecting remaining principal and interest after you exit bankruptcy.
There is a second way to handle student loans in Chapter 13 bankruptcy, and that is to pay the loans “outside of the plan”. The benefit of this approach is that you can continue to make regular payments on the loans and keep interest from piling up during the years you are in a Chapter 13 repayment plan. However, this is often limited as a practical matter because many do not have enough money to make their student loan payments while also making a Chapter 13 bankruptcy payment.
Furthermore, for those that can afford to continue making payments outside the plan, the bankruptcy Trustee may well challenge this approach if your other creditors are getting only a fraction of what you owe through the bankruptcy. Your ability to prevail in such a situation depends on a number of factors, and such cases are best handled by an experienced bankruptcy attorney.
What to do After Your Bankruptcy Discharge
Your student loans probably changed hands while your bankruptcy was pending. (Most student loans are sold to a company called ECMC once you file bankruptcy.) After your bankruptcy is over, or while your bankruptcy is pending if you plan to continue repayment, it is important to find out who holds your loans. The National Student Loan Data System can help you find out. Once you find out who your lender is, you should contact them to discuss your repayment options.
I f your student loans were in default before you filed for bankruptcy, they will continue to be in default until you work something out with your lender, such as loan rehabilitation or a default repayment plan. (Student loans go into default if you fail to make a payment for 270 days.)
Bankruptcy will not put your student loans into default. If your credit report after bankruptcy incorrectly reports the status of your loans (such as showing loans in default when you are sure they are not, or reporting that your loans were discharged in bankruptcy—they were not, unless you won an adversary proceeding against your lender) you must dispute the incorrect status with the credit bureau.
Having student loans can be a good way to begin rebuilding your credit score after your case is closed. Provided you make on-time payments and continue to pay down the balance, your student loan debt will provide a means of establishing a good credit history without taking on new debt after your bankruptcy is over.
Student loans are very difficult to get rid of in bankruptcy. You need to have real hardship and money to invest in a lawsuit (odd combination, I know). Assuming this is not you, you should have a plan for how to manage your student loans during and after bankruptcy. This is especially true in Chapter 13, where student loans present particularly thorny practical and legal issues while in bankruptcy. If you’ve read our blog in the past, you can probably guess the exciting conclusion – this is a good reason to hire a bankruptcy lawyer.