This page answers common questions about the relationship between bankruptcy and financial aid, such as student loans. The first answer concerns the impact of bankruptcy on eligibility for student loans. The second answer discusses whether student loans can be discharged through bankruptcy.
Thanks to Pat Somers of the Univ. of Arkansas at Little Rock and Art Bilski of the Illinois Student Assistance Commission for their assistance with this section.
Bankruptcy and Eligibility for Financial Aid
Will a bankruptcy affect a student’s future eligibility for student loans and other financial aid?
The answer to this question is a complex one because several issues are involved. It depends on the nature of the student loan programs (federal or private) and the type of bankruptcy.
Whatever the circumstances behind the bankruptcy, the student should talk with the financial aid administrator at the school he plans to attend, and explain the situation. The financial aid administrator may be able to guide the student to certain loan programs or lenders that may fit his needs.
Generally speaking, a bankruptcy should have no impact on eligibility for federal student aid.
A few years ago students who had their federal student loans discharged through bankruptcy were required to reaffirm the debt in order to be eligible for further federal student aid. But the Bankruptcy Reform Act of 1994 (P.L. 103-394, enacted October 22, 1994) amended the FFELP regulations dealing with loans discharged in bankruptcy. As a result of those changes, a borrower who had FFELP loans previously discharged in bankruptcy is no longer required to reaffirm those loans prior to receiving additional federal student aid.
Title IV grant or loan aid (including the Perkins loan program) may not be denied to a student who has filed bankruptcy solely on the basis of the bankruptcy determination. Financial aid administrators are precluded from citing bankruptcy as evidence of an unwillingness to repay student loans. Schools may nevertheless continue to consider the student’s post-bankruptcy credit history in determining willingness to repay the loan.
As long as there are no delinquencies or defaults on student loans currently in repayment, the student should be eligible for additional federal student loans, regardless of any past bankruptcies. However, if some of the student’s federal student loans are in default and were not included in a bankruptcy, the student will not be able to get further federal student aid until he resolves the problem. Students with loans in default should contact the lender (or servicer or current holder of the loan) to set up a satisfactory repayment plan in order to regain eligibility for federal student aid. (If the loan was discharged in bankruptcy after the borrower defaulted on the loan, it is no longer considered to be in default.)
Parents who apply for a PLUS loan (or graduate students applying for a Grad PLUS loan) may be denied a PLUS loan if they have an adverse credit history. The definition of an adverse credit history includes having had debts discharged in bankruptcy within the past five years. If this is the case, the parents may still be eligible for a PLUS loan if they secure an endorser without an adverse credit history. If the parents are turned down for a PLUS loan because of an adverse credit history, the student may be eligible for an increased unsubsidized Stafford loan.
The anti-discrimination rules appear in 11 USC 525(c):
- A governmental unit that operates a student grant or loan program and a person engaged in a business that includes the making of loans guaranteed or insured under a student loan program may not deny a student grant, loan, loan guarantee, or loan insurance to a person that is or has been a debtor under this title or a bankrupt or debtor under the Bankruptcy Act, or another person with whom the debtor or bankrupt has been associated, because the debtor or bankrupt is or has been a debtor under this title or a bankrupt or debtor under the Bankruptcy Act, has been insolvent before the commencement of a case under this title or during the pendency of the case but before the debtor is granted or denied a discharge, or has not paid a debt that is dischargeable in the case under this title or that was discharged under the Bankruptcy Act.
- In this section, “student loan program” means any program operated under title IV of the Higher Education Act of 1965 or a similar program operated under State or local law.
Private loans are an entirely different matter. Because of the many different types of bankruptcies, this is a very complex issue.
The student should contact the financial aid administrator at his school for advice on the impact of a bankruptcy on eligibility for private loans. The student should also talk to the lender and provide evidence that he is a good risk, and be prepared to explain the circumstances behind the bankruptcy. The lender may be more willing to issue a loan if the borrower offers to secure the loan. If the student is still having problems, he may want to consult the attorney who handled the bankruptcy.
Most bankruptcies will have an impact on eligibility for private loan programs, including some school loan programs. Many private loan programs have credit criteria that preclude people with a bankruptcy within the past 7 or 10 years from borrowing without a creditworthy cosigner. There are, however, exceptions if the bankruptcy was initiated for reasons beyond the borrower’s control, such as extraordinary medical costs, natural disasters, or other extenuating circumstances.
If a parent went through bankruptcy, it should have absolutely no impact on their children’s eligibility for private loans, unless the parent is required to cosign the loans.
If the bankruptcy filing included a payout plan, even if not 100%, the student will be at an advantage in applying for private loans. Bankruptcy filers with a payout plan, especially a 100% payout plan, are a better risk than most people who have gone through bankruptcy. On the other hand, if the borrower went the Chapter 7 route, he may have more difficulty in getting a private loan. Lenders tend to look less favorably on complete liquidations. Thus borrowers who filed for a Chapter 11 (or Chapter 13) and had a payout plan will be more likely to get a private loan than borrowers who filed a Chapter 7.
Lenders also look at whether the borrower is able to refile for bankruptcy. Chapter 11 filers cannot immediately refile again for bankruptcy. Although any lender should know this, they may need to be reminded. Chapter 7 files are prohibited from refiling a Chapter 7 bankruptcy for 6 years. However, Chapter 13 plans have no such restriction, so a debtor can file a Chapter 7 bankruptcy, have their debts discharged, and then file a Chapter 13 within a very short time if new debt is incurred. A debtor can file an unlimited number of Chapter 13 bankruptcies. On the other hand, Chapter 13 filers are prohibited from filing a Chapter 7 immediately.
Nevertheless, lenders tend to be wary of Chapter 13 bankruptcies because a high percentage of them are converted to Chapter 7 cases or are dismissed because the debtor is unable or unwilling to continue with the payment plan established under the Chapter 13 repayment plan.
Discharging Student Loans Through Bankruptcy
Can educational loans, such as the Federal Stafford, Federal PLUS, and private loans, be discharged through bankruptcy?
Section 523(a)(8) of the US Bankruptcy Code, at 11 U.S.C., excepts from discharge debts for “an educational benefit overpayment or loan made, insured, or guaranteed by a governmental unit, or made under any program funded in whole or in part by a governmental unit or nonprofit institution; or an obligation to repay funds received as an educational benefit, scholarship, or stipend; or any other educational loan that is a qualified education loan, as defined in section 221(d)(1) of the Internal Revenue Code of 1986, incurred by a debtor who is an individual” unless “excepting such debt from discharge under this paragraph would impose an undue hardship on the debtor and the debtor’s dependents”.
For the purpose of this paragraph, the definition of of a qualifying education loan includes loans made solely to pay the higher education expenses of an eligible student, where the student is either the debtor, the spouse of the debtor, or the dependent of the debtor. In addition, the loans must be for study at a school that is eligible to participate in Title IV programs and where the student is enrolled at least half time. Loans that don’t meet this definition, such as credit card debt, are still dischargeable even if they were used to pay for higher education expenses.
Thus FFELP and FDSLP loans, and education loans funded or guaranteed by private nonprofit organizations, are automatically nondischargeable in a bankruptcy proceeding. The only cases in which they can be discharged through bankruptcy are:
- if the borrower files an undue hardship petition
and then it is up to the judge to decide whether the loan can actually be discharged. (The Higher Education Amendments of 1998 repealed the provision that allowed for the discharge of education loans that had been in repayment for 7 years. This affects all bankruptcy proceedings initiated after October 7, 1998, regardless of whether they involve loans incurred before that date.)
Section 220 of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), P.L. 109-8, extended similar protections to “qualified education loans” starting on October 17, 2005, even when they are not funded or guaranteed by a nonprofit organization. Qualified education loans is defined to include any debt incurred by the taxpayer solely for the purpose of paying for qualified higher education expenses of the taxpayer, the taxpayer’s spouse, or any dependent of the taxpayer. (Dependency is determined as of the time the taxpayer took out the loan.) Interestingly enough, most private student loan programs seem to have some sort of nonprofit involvement.
BAPCPA also made it more difficult to file under Chapter 7. If the borrower’s income is above the median income in his/her state or is sufficient to repay 25% or more of his/her debt, the borrower will be forced to file under Chapter 13, which requires repayment over three to five years. BAPCPA also mandates credit counseling before a borrower can file for bankruptcy.
Finaid analyzed FICO score distributions before and after BAPCPA showing no appreciable increase in availability of private student loans. Some of this might be explained by the lenders believing that their loans were excepted even prior to BAPCPA. If so, why did the lenders push the BAPCPA changes based on arguments that it would increase the availability of private student loans?
It is worth noting that the extension of the bankruptcy exception to qualified education loans in 11 USC 523(a)(8)(B) cross-references IRC section 221(d)(1) for the definition of a qualified education loan. This section of the Internal Revenue Code requires the loan to be used “solely to pay qualified higher education expenses”. IRC section 221(d)(2) defines qualified higher education expenses as:
The term “qualified higher education expenses” means the cost of attendance (as defined in section 472 of the Higher Education Act of 1965, 20 U.S.C. 1087ll, as in effect on the day before the date of the enactment of this Act) at an eligible educational institution, reduced by the sum of —
- the amount excluded from gross income under section 127, 135, 529, or 530 by reason of such expenses, and
- the amount of any scholarship, allowance, or payment described in section 25A (g)(2).
So to qualify for this exception, the private student loan must be capped at the cost of attendance minus student aid, such as scholarships, and expenses paid for using amounts from employer tuition assistance, 529 college savings plans and prepaid tuition plans, US savings bonds and Coverdell education savings accounts. If a borrower were able to show that the loan exceeded the limits set by IRC section 221(d)(2), they might be able to argue that the loan was ineligible for bankruptcy protection and so should be subject to discharge. See IRS Tax Topic 456 and IRS Publication 970 for further IRS guidance on what types of expenses qualify, such as the requirement that the expenses must have been “paid or incurred within a reasonable time before or after you took out the loan” (per IRC section 221(d)(1)(B)). IRS Publication 970 provides a safe harbor of 90 days before and after the academic period to which the expenses relate. Consolidation loans and other loans used to refinance a qualified education loan also qualify, provided that there was no cash out from the refinance (or that the cash out was used solely for qualified higher education expenses). Eligible student is defined by IRC section 25A(3) as a student enrolled at least half time in a degree or certificate program at a Title IV institution (per Section 484(a)(1) of the Higher Education Act of 1965).
More details and other limitations on the exception to discharge can be found in Limitations on Exception to Discharge of Private Student Loans.
Most court cases cite Brunner v. New York State Higher Education Services Corp. (October 14, 1987, #41, Docket 87-5013) for a definition of “undue hardship”. Brunner v. NY HESC (In re Brunner), 831 F.2d 395 (2d Cir. 1987), aff’g 46 B.R. 752 (Bankr. S.D.N.Y. 1985). That decision adopted the following three-part standard for undue hardship:
- That the debtor cannot both repay the student loan and maintain a minimal standard of living based on current income and expenses.
- That this situation is likely to persist for a significant portion of the repayment period of the student loans.
- That the debtor has made good faith efforts to repay the loans.
The first element of the standard usually involves the lowest monthly payment available to the borrower, namely the monthly loan payment under Income Contingent Repayment, as opposed to standard ten-year repayment. (With the introduction of Income Based Repayment on July 1, 2009, it is expected that the courts will switch to this repayment plan as it usually yields a lower monthly payment and meshes well with the 150% of poverty line threshold for a bankruptcy fee waiver.) Note that if the borrower has multiple student loans and could afford to repay some but not all of them, the court will generally discharge only those loans that exceed the borrower’s ability to repay. It is also possible that a court will discharge part of a loan instead of the entire loan.
The poverty line is often (but not always) used as a threshold for a minimal standard of living, since it is defined as the income level at which the family has no discretion concerning how to use the income. However, the courts will generally examine all of the debtor’s expenses to ensure that they are minimal and necessary. The existence of discretionary expenses may derail an undue hardship petition, as borrowers are expected to make sacrifices to repay their debts.
The second element of the standard requires the debtor to provide evidence of additional exceptional circumstances that are strongly suggestive of a continuing insurmountable inability to repay, such as being disabled or having a disabled dependent. A serious physical or mental illness might also qualify. An inability to work in one’s chosen profession does not necessarily preclude being able to work in another field. There must be a “certainty of hopelessness”, meaning that there is no chance of any future improvement in the borrower’s financial situation.
The third element of the standard requires the borrower to have demonstrated a good faith effort to repay the loans. Filing for a bankruptcy discharge immediately after graduation is generally not considered a good faith effort to repay the loans. However, there might be extenuating circumstances, such as the debtor suffering brain damage in a car accident shortly after graduation. The court will consider the totality of the circumstances. The court will consider whether the debtor made payments on the loans when he or she had some income available and obtained a deferment or forbearance when his or her income was insufficient. The court will also consider whether the debtor took advantage of various alternatives to bankruptcy, such as the extended repayment, income-contingent repayment and income-based repayment plans, and whether the debtor tried to increase available financial resources, such as seeking a better job and reducing expenses.
Other standards besides Brunner v NY HESC that are sometimes cited by courts include:
- Johnson Test. PHEAA v. Johnson (In re Johnson), 5 Bankr. Ct. Dec. 532 (Bankr. E.D.Pa. 1979). This test considers the borrower’s current and future ability to repay the debt while maintaining a minimal standard of living. It considers the borrowers current and future employment and other factors that may affect income, such as education, health and dependents. It compares this income with the federal poverty line. This test also considers good faith efforts to repay the debt, such as whether the borrower tried to maximize income and minimize expenses and whether the borrower was responsible for causing his or her current financial situation through irresponsible or negligent behavior.
- Totality of Circumstances Test. Andrews v. South Dakota Student Loan Assistance Corporation, 661 F.2d702 (8th Cir. 1981). This test considers the combined impact of all the various factors affecting the borrower’s ability to repay the debt on a case-by-case basis. It considers the borrower’s past, present and future financial resources, using reasonable estimates of future resources. It also calculates the reasonable living expenses of the borrower and his/her dependents and calculates debt to income ratios. It considers the duration of the hardship, such as whether the borrower is permanently or temporarily disabled. It also considers whether the borrower has sought other available options for relief.
- Bryant Poverty Test. Bryant v. PHEAA (In re Bryant), 72 B.R. 913 (Bankr. E.D. Pa. 1987). This test considers whether the borrower’s after-tax net income is near or below the federal poverty level as the primary means test for undue hardship.
A debtor could have a zero payment under the income-contingent or income-based repayment plans if the debtor’s discretionary income is zero. Of the more than 600,000 borrowers repaying their federal education loans using the income-contingent repayment plan, more than 285,000 (45%) have a zero payment. This does not prevent an undue hardship discharge for federal education loans if the debtor is unable to maintain a minimal standard of living even with a zero payment and the situation is likely to persist for most of the life of the loans. But most often an undue hardship discharge is applied to private student loans which don’t offer such generous repayment plans.
Even if a loan doesn’t come under the non-discharge provision for student loans under the Bankruptcy Code, the debtor’s petition would still be reviewed and could be denied on various other grounds, such as abuse of the bankruptcy laws.
34 CFR 685.212 describes the conditions for discharge of a loan obligation under the federal direct loan program, and includes the following statement on bankruptcy:
(c) Bankruptcy. If a borrower’s obligation to repay a loan is discharged in bankruptcy, the Secretary does not require the borrower or any endorser to make any further payments on the loan.
Page 2-32 of the Federal Student Financial Aid Handbook states:
A student with an SFA loan discharged in bankruptcy is eligible for SFA grants, work-study, and loans. Prior to October 22, 1994, a student whose defaulted loan was discharged in bankruptcy could not receive loan funds unless the student reaffirmed the discharged debt and made satisfactory repayment arrangements. Because of legislative changes made by the Bankruptcy Reform Act of 1994, the reaffirmation requirement was lifted. Students no longer must reaffirm discharged loans before receiving new loans. In addition, if a student has a loan stayed in bankruptcy, he or she remains eligible for SFA funds as long as he or she has no loans in default (including the stayed loan) and as long as all other eligibility requirements are met.
Regardless of whether the education loan is dischargeable, the debtor should consider objecting to the claim of the holder of the loan in a Chapter 13 proceeding. This requires the creditor to provide an accounting of the amount owed and any additional charges and fees that were applied to the loan balance. Often lender records are in a state of disarray (especially if the loan has been sold) and it will be unclear how much is actually owed. The burden of proof is on the lender, not the debtor (although it is helpful if the debtor has cancelled checks and other records of payments made). The judge will then decide the amount that is properly owed.
Low Odds of a Successful Undue Hardship Discharge
Borrowers are extremely unlikely to successfully obtain an undue hardship discharge in part because Congress never defined what it meant by an undue hardship, leading to arbitrary and capricious bankruptcy court decisions. For example, the Chronicle of Higher Education reported on November 29, 2009 that Educational Credit Management Corporation (a guarantee agency with expertise in servicing federal education loans of borrowers who are filing for bankruptcy) held the federal student loans for roughly 72,000 borrowers in bankruptcy in 2008, but that only 276 (0.4%) sought a bankruptcy discharge for the student loans. Most bankruptcy attorneys won’t even try to get federal student loans discharged. Of the 134 cases that have been resolved, only 29 (22%) had all or part of their student loans discharged.
Success rates might be somewhat higher for private student loans since private student loans don’t offer nearly as many consumer protections or options for repayment relief as federal loans. For example, private student loans do not generally provide borrowers with income-based or income-contingent repayment or with a disability discharge, and forbearances are more limited. However, anecdotal evidence suggests that less than 1% of private student loan borrowers in bankruptcy seek an undue hardship discharge and that less than half of them are successful in obtaining a full or partial discharge.
Attempts to Repeal the Exception to Discharge
Several members of Congress have attempted unsuccessfully to ease the restrictions on bankruptcy discharge of private student loans.
- On May 26, 2011, Rep. Steve Cohen introduced the Private Student Loan Bankruptcy Fairness Act of 2011 (H.R. 2028) and Sen. Dick Durbin introduced the Fairness for Struggling Students Act (S. 1102). Both bills would repeal the exception to discharge for private student loans. The House version would preserve an exception for loan programs for which substantially all of the funds are provided by a nonprofit institution, while the Senate version would repeal the exception to discharge for all private student loans, regardless of whether the loans were made by a for-profit or non-profit organization. Both bills would preserve the exception to discharge for federal and state student loan programs.
- On April 15, 2010, related bills were introduced in the US Senate and US House of Representatives. Senators Dick Durbin (D-IL), Sheldon Whitehouse (D-RI) and Al Franken (D-MN) introduced the Fairness for Struggling Students Act (S.3219) in the US Senate and Congressmen Steve Cohen (D-TN) and Danny Davis (D-IL) introduced the Private Student Loan Bankruptcy Fairness Act of 2010 (H.R. 5043) in the US House of Representatives. The Senate and House amendments differ somewhat. Both repeal the exception for qualified education loans. The Senate version strikes the exception for nonprofit institutions, while the House version retains it with a requirement that substantially all of the funds for the loan were provided by a nonprofit institution. The Senate version clarifies that the exception for obligations to repay funds is limited to funds received from a governmental unit. Previously some lenders have argued that this language included loans, not just grant overpayments. Private student loans offered through state loan agencies would continue to be excepted from discharge under both the House and Senate versions of the legislation.
- On February 7, 2008, an amendment to the Higher Education Opportunity Act of 2008 (P.L. 110-315) proposed by Rep. Danny K. Davis failed by a vote of 179 to 236, with 170 Democrats and 9 Republicans voting in favor and 52 Democrats and 184 Republicans voting against. This amendment would have allowed private student loans to be discharged after 5 years in repayment. It would also have closed a loophole whereby mere association of a for-profit loan program with a non-profit entity made a private student loan nondischargeable even though the non-profit entity was not the source of funding for the loans.
- On June 7, 2007, Sen. Dick Durbin introduced a bill, S.1561, to repeal the exceptions to discharge for private student loans. The bill was referred to the Committee on the Judiciary and was never reported out of committee.
- On May 26, 2006, Senator Clinton introduced the Student Borrower Bill of Rights Act of 2006 (S.3255). She reintroduced it on February 7, 2007, as the Student Borrower Bill of Rights Act of 2007 (S.511). Among other provisions, the bill would have allowed new federal and private student loans to be discharged after 7 years in repayment. The bill was referred to the Committee on Health, Education, Labor and Pensions and was never reported out of committee.
Bankruptcy Discharge of Unpaid Tuition Bills
Can unpaid tuition bills and other unpaid college charges be discharged in bankruptcy?
Generally, so long as the family did not sign a promissory note with the college, unpaid tuition bills and other college bills can be discharged in bankruptcy.
Whether unpaid tuition bills are excepted from discharge depends on whether they are considered an education loan or a contractual obligation. Education loans are excepted from discharge under section 11 USC 523(a)(8) of the US Bankruptcy Code. Contractual obligations are not.
An unpaid tuition bill will be considered an education loan if they are evidenced by a promissory note. A promissory note is an agreement, executed before or at the same time as the transaction, that provides for a definite sum to be repaid by the borrower by a specified date according to a specified schedule, with a specified amount of interest. When there is no promissory note, bankruptcy courts have held that no loan exists. So whether unpaid tuition bills are considered an education loan will therefore depend on a review of all documents signed in connection with the unpaid tuition bills.
The most important relevant precedents include In re Kevin Renshaw and In re David Regner, 222 F3d 82 (US Court of Appeals for the Second Circuit, 2000) and In Re: Sandra Ann Chambers, 348 F3d 650 (US Court of Appeals for the Seventh Circuit, 2003), where the court held that unpaid tuition bills were not an education loan and hence could be discharged. On the other hand, the court held in the case In re Johnson 218 BR 449,455 (8th Cir. BAP 1998) that the plaintiff had executed a promissory note and so the debt was not dischargeable.
It is not entirely clear whether a tuition installment plan would be considered an education loan for the purpose of bankruptcy discharge. In most cases the college arranges with a third party to process the billing and payments. The family’s contract with the payment processor has many elements of a promissory note. Yet most of these companies specifically state that the tuition installment plan is not a loan and does not charge interest and just charge an up front nonrefundable fee and many offer loans as an alternative.
Note that while a college may withhold official academic transcripts for nonpayment of college bills, as soon as the student files for bankruptcy the college may no longer withhold transcripts during the pendency of the case because of the automatic stay provision of the bankruptcy code. Likewise, the college may not refuse to provide an official academic transcript after the debt is discharged because of the discharge injunction.
Types of Bankruptcies
This section provides a short glossary of the different types of bankruptcies. As noted above, bankruptcy does not relieve you of the obligation of repaying your student loans. It also does not affect child support and alimony payments, and income tax obligations.
- Chapter 7 Complete liquidation of all personal assets to repay debts.
- Chapters 11 Reorganization bankruptcy in which a plan is filed with the court to repay creditors. Chapter 11 is used for debts in excess of $1 million and is used mainly by businesses.
- Chapter 12A bankruptcy for family farmers.
- Chapters 13 Reorganization bankruptcy in which a plan is filed with the court to repay creditors. Chapter 13 is used for debts under $1 million and is used mainly by consumers.