Discharging Student Loans in Bankruptcy – Is It Possible?
Federally guaranteed student loans were first available after passage of the Higher Education Act of 1965. The Education Amendments Act of 1976 prohibited borrowers from discharging federal student loans in bankruptcy during the first five years of repayment unless the borrower could establish that repayment of the loans would constitute an “undue hardship.” That period was later changed to seven years. Under that scheme, seven years after the first payment became due, a federal student loan could be discharged in the same way as other unsecured loans.
The Higher Education Amendments of 1998 removed the 7-year limitation of the undue hardship rule, making all federal loans subject to this requirement, regardless of age. The 1998 law also made it possible for lenders to assess penalties and collection fees for missed payments and defaulted loans.
In 2005, Congress enacted The Bankruptcy Abuse Prevention and Consumer Protection Act, which removed the option of routinely discharging private student loans in bankruptcy. However, unlike federal loans, a private lender must file a lawsuit within the time allowed by the applicable statute of limitations. If the lender does not do so, the loan become “time-barred” and essentially uncollectible.
The statutory changes made from 1998 to 2005 have been detrimental to those who borrowed heavily to finance their education, or co-signed a loan for a family member, and are unable to make payments.
In 2021, a Senate bill (The Fresh Start Through Bankruptcy Act) was introduced which would restore bankruptcy protections to student loans by making them dischargeable 10 years after payments become due. The bill did not receive enough support to move past the committee stage.
“Undue Hardship” Discharge of Student Loans
The bankruptcy court’s power to grant a discharge of a guaranteed student loan is based on Section 528 (a)(8) of the bankruptcy code, which authorizes a discharge if repayment of the loan would cause an “undue hardship.”
Most bankruptcy attorneys turn away clients who are seeking to discharge student loans in bankruptcy. There are at least two reasons for this avoidance. First, discharging a student loan must be attempted through an “adversary action.” This is a lawsuit that will be decided by the bankruptcy court judge. Evidence is presented to support or refute the claim that repayment of the student loan constitutes an undue hardship. While some cases are settled early, leading to a discharge of the borrower’s loans, most cases are litigated. In those cases, the government or private lender will try and prevent the undue hardship discharge. The time involved in this process leads to significant legal costs that most debtors cannot afford to pay. Debtors who are likely to qualify for the hardship discharge are typically not able to pay significant fees to the bankruptcy attorney.
Secondly, the criteria for determining “undue hardship” was not written into the bankruptcy code. It was left to the courts to determine what factors would be considered in determining which loans would be discharged. Over time, that standard has become more and more difficult to satisfy.
California bankruptcy courts apply the following “undue hardship” standard:
- The debtor cannot maintain, based on current income and expenses, a minimal standard of living for herself and her dependents if forced to repay the loans;
- Additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period of the student loans; and
- The debtor has made good faith efforts to repay the loans.
See: Brunner v. New York State Higher Education Services Corp., 831 F. 2d 395, 396 (2nd Cir. 1987); United Student Aid Funds, Inc. v. Pena, 155 F. 3d 1108 (9th Cir. 1998)
For the first prong, the debtor must show that he/she can only afford modest living expenses on his/her current income, and cannot afford to make payments on the student loan. (If there is disposable income available, a debtor may be entitled to a partial discharge.)
The second prong has been interpreted to require the that the debtor establish that he/she does not have options to generate more income in the foreseeable future, through promotions or higher-paying jobs.
The court may find undue hardship when a debtor has reached the maximum potential income for her education and skills, and cannot afford to make loan payments on that income. See In Re Nys 446 F. 3d 938 (9th Cir. 2006).
The third prong is satisfied by showing that the debtor sought deferments and/or forbearances when they were available, made payments when he/she was able to, and made efforts to avoid default.
Are You a Candidate for a Discharge Based On Undue Hardship?
Consider pursuing a discharge of student loans if you:
- Are permanently disabled (no longer work, and do not expect to work)
- Are age 55 or older, have been in the workforce for 20 years or more, and are unable to increase your income or afford loan payments on your current income.
- Have dependents, and support of dependents is expected continue for at least ten years, or the remainder of the repayment period.