What Happens to Your Student Loans if You Declare Bankruptcy?March 21, 2021
Bankruptcy can provide relief to people who are struggling financially and don’t have any other options.
But, unfortunately, bankruptcy and student loans don’t always mix well. While filing bankruptcy on student loans is possible, it’s not easy to prove what you have to in order to get the petition approved by the court. Here’s what you should know.
How Your Bankruptcy Type Affects Your Student Loans
Bankruptcy is typically considered a last resort when consolidation, credit counseling, and even debt settlement are either unavailable or ineffective for your situation.
There are two types of consumer bankruptcy in the U.S., Chapter 7 and Chapter 13.
Chapter 7 Bankruptcy
Also called liquidation bankruptcy, Chapter 7 is reserved for low-income borrowers who can pass a means test. The idea is that your financial situation is so dire that you can’t even afford to make payments on a restructured plan. With this option, some of your assets will be liquidated (with exceptions) to pay off some of what you owe, then the rest will be canceled.
But student loans aren’t automatically included like other forms of unsecured debt. You’ll need to file an additional complaint to have them considered for discharge.
You’ll also need to provide evidence that your financial hardship is so severe that you cannot pay your student loans, even if your other debts are wiped out.
Many people take this to mean that there’s no way to get their student loan debt discharged in bankruptcy. As a result, only 0.1% of people who file for bankruptcy even try to include their student loan debt, according to a 2011 study that’s often cited by industry experts.
That said, the study also pointed out that 40% of people who filed to have their student loans discharged received approval from the judge. So while it can be difficult, that’s not to say it’s impossible.
While your student loan servicer or lender can oppose your petition, the court will use one of two tests to determine your eligibility for undue hardship:
- Brunner test: With this test, you have to show that you’ve made a good-faith effort to pay back your student loans, your financial situation is unlikely to change anytime soon, and paying back your debt will make it impossible for you to maintain a minimal standard of living.
- Totality of circumstances test: This option is a bit broad, in which the court considers your reasonably necessary living expenses, your past, present and likely future financial resources, and other relevant factors.
Chapter 13 Bankruptcy
This type of bankruptcy is sometimes called reorganization bankruptcy because instead of getting rid of your debts, it reorganizes them in a way that helps you to afford your monthly payments. In the end, you’ll typically pay less than what you owe, but you must agree and stick to the new payment plan to complete the process.
Student loans are generally considered to be non-priority debts when it comes to Chapter 13 bankruptcy. This means that they’re not like child support, alimony, and certain taxes, which are not at all includable.
But compared with credit card debt, medical bills, personal loans, and utility bills, student loans are low on the totem pole, so to speak.
That said, it is possible for you to get lower monthly payments on your student loans by including them. But that doesn’t mean the remaining balance will be discharged once your three-to-five-year plan has been completed.
In fact, if your student loans don’t get canceled after that period ends, you’ll be stuck with the remaining balance plus all of the interest that accrued during that time.
Is It Worth It to Try to Mix Bankruptcy and Student Loans?
It is possible to have your bankruptcy include student loan debt. But there are many things to consider before you move forward with that decision.
With Chapter 13, for instance, you’ll want to get an idea of whether your debt could be dischargeable once you’re finished with your reorganization payment plan. If not, you could end up in a worse situation with your student loans than when you started.
And if you’re considering Chapter 7 bankruptcy, you’ll want to find out which test the local court uses to determine whether you qualify.
With either option, you’ll need to remember that your lender may oppose your petition. That doesn’t mean you don’t have a chance of having it approved, but it can slow the process down. Before filing for bankruptcy with student loans, be sure you’ve collected all the necessary information to ensure the smoothest possible process.
Finally, whether or not you include your student loans in bankruptcy, the public record will be added to your credit reports and will remain on them for seven years for Chapter 13 and 10 years for Chapter 7. It can have a significant negative impact on your credit score and make it difficult to get approved for financing in the future when you need it.
In any event, it’s a good idea to consult with a bankruptcy attorney before you decide whether filing bankruptcy on student loans is the right move for you.
What to Consider Before Resorting to Bankruptcy
Bankruptcy and student loans can present a challenge and may have a long-term impact if things don’t go your way.
Before you think about filing bankruptcy on student loans, consider these alternatives:
- Income-driven repayment: If you have federal student loans, an income-driven repayment plan can slash your monthly payment to a fraction of your income. What’s more, if you have a balance remaining after your repayment term ends — 20 or 25 years, depending on the plan — it will be forgiven.
- Consolidation: Again, if you have federal student loans, another alternative is to consolidate your debt. With consolidation, you may be able to get a repayment term of up to 30 years, which can decrease your payment significantly. Just keep in mind that the Direct Loan Consolidation program may raise your interest rate slightly.
- Refinancing: Student loan refinancing involves replacing your existing loans with a new one through a private lender. It generally requires a good credit score and solid income, so you may need a cosigner if you can’t get approved on your own. But if you’re eligible, you could qualify for a lower interest rate and a smaller monthly payment.
- Credit counseling: There are several nonprofit counseling agencies that can help you figure out how to improve your money management. These sessions are typically free and can help you figure out what to do based on your current situation and your future prospects. You can find a local agency through the National Foundation for Credit Counseling.
Regardless of which path you choose, it’s important to take the time to research your options and weigh the benefits and drawbacks of each. While bankruptcy may sound like the easy way out, it often makes things more complicated in the long run.
If you have explored all of your other options, though, consult with a bankruptcy lawyer to figure out whether you can succeed in getting your student loans discharged and the next steps to achieve that goal.