Student Loans

In the United States, there are two types of student loans. “Government student loans” are those that are issued or guaranteed by the federal government. Examples are Direct Loans, Perkins Loans, and Stafford Loans. “Private student loans” are made by nongovernment lenders, such as banks or Sallie Mae (a large, private student loan company).

Government loans have lower interest rates and more flexible terms than do private student loans. As such, they are more desirable. However, government loans have strict limits as to how much money can be borrowed. As a result, many students are forced to take out private loans to supplement the financial aid offered by their school and by the government.

Until 1976, all student loans were dischargeable as part of a bankruptcy filing, just like credit card debts and auto loans. Over the years, however, the bankruptcy laws were changed incrementally to become more and more restrictive with respect to student loans. This happened in 1978, 1979, 1984, 1990, 1991, 1993, 1996, 2005, and 2006.

The overall impact of these changes is that (with one exception we will discuss in a moment) student loans — both government and private — are no longer eligible to be discharged via bankruptcy. Student loans are considered to be priority debts, as I mentioned earlier in the section on Chapter 7 bankruptcy. This places student loans in the same category as taxes, child support, alimony, criminal fines, and criminal restitution.

However, as I mentioned, there is one exception. It is possible to discharge student loans if paying back the debt “would impose an undue hardship on the debtor and the debtor’s dependents”. (This quote comes from the U.S. Code, Title 11, Chapter 5, Subchapter II, Section 523a(8).) Although the possibility sounds promising, in practice it is difficult for a debtor to qualify for two reasons.

First, a request to discharge a student loan cannot be included as part of a general bankruptcy filing. Instead, the debtor must file a petition for a separate adversary proceeding. (In the American legal system, an “adversary proceeding” is a lawsuit filed by one party against another.) In other words, in order to attempt to discharge a student loan, a debtor must initiate a lawsuit separate from the main bankruptcy filing.

Second, the law does not specify what is meant by “undue hardship.” It is up to a bankruptcy judge to decide, and many judges are reluctant to approve such discharges.

To determine if someone is eligible to discharge a student loan, U.S. bankruptcy courts often use the so-called “Brunner test.” (The name comes from a 1987 court case involving a debtor named Marie Brunner; if you want to look it up, the citation is “831 F.2d 395”.) Below is the definition of the Brunner test as specified in the original court ruling.

Before the discharge of a student loan can be approved, it must be demonstrated to the judge’s satisfaction that the following three conditions are met:

1. “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.”

2. “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.”

3. “The debtor has made good faith efforts to repay the loans.”

If you find yourself in such a position, and you believe you are otherwise eligible for bankruptcy, you can consider filing a petition for a separate adversary proceeding to try to discharge your student loan. In such cases, it is wise to hire a trustee who has specific experience (and success) with discharging student loans. The process is not as straightforward as a regular Chapter 7 or Chapter 13 bankruptcy filing, so you will need a specialist.

Author’s Note: “Understanding Bankruptcy” is a series of seven columns to help you understand our modern bankruptcy system and how it works. I suggest that you start with the first column and read them in order, if you have not already done so. As a reference aid, I have created a comprehensive glossary of bankruptcy-related terms. You can find it in the “Money and Economics” section of my website, harley.com.