Proposed Legislation May Reclassify Student Loans in Bankruptcy

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Even as the economy begins to improve, many new graduates struggle with repaying their student loans. The United States Student Association estimates that borrowers hold $730 billion in student loan debt, with 60 percent ($440 billion) in deferment or default. With student loan debt outgrowing credit card debt, some are considering bankruptcy, even though current law does not allow discharge of such debt, except under limited circumstances.

There is growing speculation that this may change. In April 2010, Senators Richard Durbin (D-IL) and Al Franken (D-MN) introduced the Fairness for Struggling Students Act, while Congressmen Steve Cohen (D-TN) and Danny Davis (D-IL) brought the Private Student Loan Bankruptcy Forgiveness Act to the House of Representatives. These bills may change the status of student loans in bankruptcy.

Under the U.S. Bankruptcy Code, education loans fall under the status of non-dischargeable debt, which cannot be cancelled through bankruptcy absent a showing of “undue hardship,” a difficult legal standard to satisfy. A borrower must show:

  • Inability to maintain a minimum standard of living while paying the loans
  • Likelihood of poor financial situation continuing
  • Good faith effort to repay the loans

Even with such a high standard, bankruptcy judges are still reluctant to discharge education loans to relive students’debt problems.

Current law defines “education loans” as federally funded student loans, as well as private loans issued by private banks. Prior to the revision of the bankruptcy law in 2005, private educational loans were treated like any other consumer debt. The proposed legislation would reclassify private educational loans as consumer loans, which would enable them to be discharged like credit cards, car loans and other types of privately issued debt.

“The 2005 bankruptcy restrictions penalize borrowers for pursuing higher education [and] provide no incentive to private lenders to lend responsibly,” says Representative Davis in explaining his bill. Senator Durbin reasoned that his legislation is designed to “restore fairness in student lending by treating privately issued student loans in bankruptcy the same way other types of private debt are treated.”

Some lenders are ambivalent about the proposed changes, believing that private lenders should not be singled out. However, student organizations such as StudentLoanJustice.org insist that bankruptcy protection should be extended to all student loans, regardless of the source. Even Sallie Mae, which issues a majority of private student loans in the United States, suggests that student loans should be dischargeable in bankruptcy if the borrower has made a good faith effort over the past five years and is still experiencing financial difficulty.

Those in dire financial straits should consult a bankruptcy attorney to learn more about their rights and options in discharging student loan debt.

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